Big Banks Are Still Risky Investments

Big bank stocks had a good showing last week, with share prices rising across the board.

The six biggest U.S. banks by market capitalization gained an average of 8% during the holiday-shortened week in which each released its 2011 fourth-quarter earnings. Since the financial sector is the second-largest component of the S&P 500 – with a combined market cap of $1.67 trillion – this strength helped drive the broad-market index to a weekly gain of 1.7%.

The strong rise in their shares might suggest that the big banks posted blowout earnings. However, that was not the case.

As Rick Pendergraft – my colleague and editor of ETF Master Portfolio – wrote yesterday, the bar had been set so low for the big banks that even mild earnings improvements were enough to send the beaten-down stocks surging in a market desperate for signs of life.

To wit: Morgan Stanley (NYSE: MS) lost $275 million for the quarter after reporting a profit of $600 million during the same period a year ago.  But the 15-cents-per-share loss was "better" than analysts’ expectations of 43 cents per share in losses, sending the stock up a whopping 13.2% for the week.

Goldman Sachs (NYSE: GS) followed a similar track. The extreme volatility in the market took its toll on the investment banking giant, sending its year-over-year profits spiraling down 58%. Nevertheless, Goldman’s $1.84 per share in quarterly earnings beat the consensus analyst forecast of $1.23 per share. That was enough to send the stock up 11.3% for the week.

JPMorgan Chase (NYSE: JPM) and Citigroup (NYSE: C) also posted weekly gains of more than 5% despite quarterly earnings that trailed last year’s profits.

Among the big boys, only Bank of America (NYSE: BAC) and Wells Fargo (NYSE: WFC) managed earnings that were an improvement over the 2010 fourth quarter.

So last week’s earnings were not a turning point signaling a return to pre-recession glory for the financial sector. The market just made it seem like one. That’s what happens to stocks that have been almost universally hated since the recession – expectations are so minimal that even narrow misses are treated like rousing victories.

True, Bank of America and Wells Fargo booked actual fourth-quarter profits. But B of A’s rang a bit hollow. Much of its earnings boost came from selling assets rather than its regular operations.

Wells Fargo was the one bank that scored meaningful improvements. Its 20% jump in fourth-quarter profits stemmed largely from returns in its giant mortgage business – the largest in the nation, with a 30% market share. Even so, Wells Fargo’s fourth-quarter revenue declined 4% from a year ago.

That was a common theme among all the big banks last quarter. While lending is picking up, mortgage businesses are stabilizing and more borrowers are paying their debts on time, it isn’t translating to revenue growth. The volatile market returned less underwriting revenue on stock and bond offerings for banks. And that’s why investment banks such as Goldman Sachs and Morgan Stanley struggled so mightily.

Yet the overall earnings news was enough to send these stocks soaring. In fact, big bank stocks have been on the rise for nearly four months now. The Financial Select Sector SPDR ETF (NYSEARCA: XLF) is up 9% in 2012 and 21% since a brutal Thanksgiving week.  By comparison, the S&P 500 is up around 13% since Thanksgiving.

So why are these stocks rising in spite of lackluster financial performance?

Chalk it up to very modest improvements on the heels of a terrible year. Despite the late-year gains, financials were the worst-performing broad market sector in 2011, declining 18% compared to a 2% drop-off for the market as a whole. Considering that all six big bank stocks reached their lowest level during the fourth quarter since the height of the recession in March 2009, it’s no surprise that they’ve bounced back in the last few months. A correction of some kind was inevitable.

Still, it doesn’t mean U.S. banks are out of the woods yet. You shouldn’t go buying up Bank of America and Wells Fargo just because those stocks are on the upswing. Until the big banks can produce consistent, meaningful profits across the board, their stocks will remain risky long-term buys.

The banks beat low expectations last quarter to post some healthy gains. But with those gains comes raised expectations. The higher the expectations get, the more difficulty the banks will have exceeding them. Investors would be better served waiting until the big banks prove they can do that.   

Full Disclosure: I currently own shares of Goldman Sachs.

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