The sector has had a good run, but it won't continue to deliver the same returns over the next several months. By Elizabeth Leary, Contributing Editor September 29, 2009 Unless you’ve been living in a cave for the past six months, you probably already know that bank stocks have staged a remarkable recovery from their March lows. Investors have moved on from pricing bank shares on their worst-case-scenario liquidation values and have begun to factor in an eventual return to normal profitability. Bank stocks in Standard & Poor’s 500-stock index soared 137% from the market’s lows in early March through September 27; over the same period, the S&P 500 itself jumped 56%. Unfortunately, you can say goodbye to the easy money. Buying a broad stake in this sector won’t prove as profitable over the next six months as it has over the past six. “Valuations are pricier than they once were,” says S&P analyst Stuart Plesser. To be sure, the sector has plenty of long-term positives. As Dick Bove, analyst for Rochdale Securities, explains, the banking system is better capitalized than it has been in 70 years. Loans have fallen as a percentage of banks’ balance sheets, and the industry is sitting on piles of cash. All this adds up to what Bove calls an eventual explosion in new lending that will potentially fuel earnings growth of 300% to 500% within the first few years of a return to normal profitability. This is the still-distant development that investors have been focusing on for the past few months: an eventual return to “normalized earnings” (or earnings smoothed out for cyclical bumps) and the potential for the coiled spring of lending activity to drive meaningful growth. Advertisement The problem is that “it may take years for bank earnings to justify current bank-stock prices” by returning to normalized levels, says Bove. He thinks this could happen in 2011, while Plesser doesn’t see it occurring until 2012. In the meantime, despite having already written off about $227 billion in loans, the industry still has a $332-billion pile of nonperforming loans and loans that are 90 days or more past due, and this pile is still getting bigger. The pace of the growth of bad loans is starting to slow, but over the course of the crisis, troubled loans have grown faster than loan-loss reserves -- so much so that loss reserves currently cover only about half of the industry’s total amount in nonperforming loans. As long as that figure continues to increase, banks will need to keep adding to loan-loss reserves, decreasing earnings. “The loan-loss provision line is the key” number investors will be focusing on as banks start reporting third-quarter earnings in October, Plesser says. When loan losses will turn is anyone’s guess, as the timing will depend largely on the strength of the broader economy. Consumer and credit-card loan portfolios remain troubled, housing prices continue to deliver unpleasant surprises and many investors are concerned that problems in commercial real estate could form the next major hurdle for banks. “If unemployment doesn’t come down, office buildings won’t get filled up, shopping centers will not get used and hotels will not have the same levels of traffic,” Bove says. Advertisement Another negative for the sector? Banks will have to cough up the cash to replenish the Federal Deposit Insurance Corp.’s deposit-insurance fund. The FDIC has paid out more than $45 billion over the past year to make whole depositors of failed institutions, and the agency recently revealed its fund has slipped into negative territory. The FDIC gets its funds by charging banks premiums and has the authority to charge special assessments when its kitty gets low. By Bove’s estimates, the special premiums the agency might reasonably charge in the next year could sop up as much as one-third of the industry’s 2010 profits. Stock prices are likely to remain volatile as investors watch for how well the economic recovery translates into lower loan-loss provisions and what form financial regulation takes. Bove thinks there is a good chance that volatility will lead to significant markdowns in bank share prices over the next few months as the market muddles through mixed news. For now, Bove is so concerned about new regulation that he says investors ought to steer clear of plain-vanilla banks. Authorities “are saying they want stronger capital requirements and more regulation,” he says. “They’re moving toward making the banks public utilities. You want to look for an institution that can’t be heavily regulated, either because it isn’t a bank or because it has the ability to sidestep regulation.” Advertisement He likes investment banks Goldman Sachs (symbol GS, $179.50), Morgan Stanley (MS, $30.55) and Lazard Ltd. (LAZ, $37.97). “It’s quite likely that the more rigorous the regulation is, the more you’ll improve the competitive positions of the investment banks relative to other banks,” he says. (All share prices are as of the September 27 close.) Plesser, however, still sees some value among the large, diversified money-center banks he covers. He has “strong buy” ratings on JPMorgan Chase & Co. (JPM, $43.65) and Bank of America (BAC, $16.60). Thanks to its relatively conservative balance sheet, JPMorgan is much closer to a return to normalized earnings than any of the other big names, he explains. The case for Bank of America is a bit speculative. The bank has said that one of its top priorities is to repay the $45 billion in Troubled Asset Relief Program funds it received. “I think it has the capital to pay back all the money now, but the government is unwilling to allow that,” Plesser says. Still, he expects the company to repay a portion of the funds before the end of the year. He thinks investors would reward the move, seeing it as a show of stability.