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Will bank stocks soar or dive in 2010?

Andrew Leckey

Andrew Leckey

Bank stocks rose like a phoenix from the financial ashes over the past year or so, lifting the results of the funds that owned them as well.

It would seem logical that an economic recovery would loft them even higher in 2010. The problem is that nagging questions about government intervention, housing and consumer credit may weigh them down.

Funds loaded with bank stocks have a tough act to follow:

Financial services mutual funds rose more than 40 percent over the past 12 months, while the Financial Select Sector SPDR (XLF) exchange-traded fund gained more than 50 percent.

“The news in banking has become ‘less bad’ this year, the surprises are pretty much over and the healing process is in full force,” observed David Ellison, portfolio manager of FBR Small Cap Financial Fund (FBRSX), up nearly 40 percent over the past 12 months. “You make money in financial stocks buying when things are ugly, which they still are, on the hope that they’ll improve to OK to good to great.”

Many bank-stock investors are avoiding those overly dependent on credit cards, mortgages or auto lending. Traits of different banks have become more evident.

“The banks that got into trouble the earliest also got into the deepest trouble and have been the ones lagging behind,” explained Jaime Peters, banking analyst with Morningstar Inc. in Chicago. “You’ll want the stock of banks that have performed fairly well through the cycle, since we still have a lot of questions about the economy and regulations hanging over the industry.”

No one is certain if the economy is really recovering or a “stimulus program pop-up” is masking an economic double dip, cautioned Peters. And then there’s the government to try to figure out.

“The situation in Washington has become frightening to folks who follow the banking stocks,” said Richard Bove, banking analyst with Rochdale Securities, Stamford, Conn. “If one believed the government would do all the things it has talked about in regard to the banks, it would be extremely negative for the industry.”

In Bove’s view, the government basically believes the industry makes too much money and is too big, so it is considering legislation to reduce the size of the biggest banks. Yet no one quite knows how all the political invective will actually play out.

The enormous compensation of bank CEOs following a period of economic woe provides powerful headline news that has raised the ire of average citizens, as well as President Obama.

Leading the pack of big-buck bankers in 2009 were John Stumpf of Wells Fargo & Co. with $18.7 million in total compensation and Jamie Dimon of JPMorgan Chase & Co., who pulled in $17.6 million.

Though many critics would object, Ellison advises putting anger on hold for a while because there are higher-priority matters to attend to as the industry tries to work its way through an abnormal period.

“I feel investors should worry about CEO pay later, not now, and instead focus on companies becoming healthier by getting their arms around their non-performing loans and reducing them,” said Ellison. “You really want to see banks building their franchises and cutting costs.”

Bank of New York Mellon (BK) and Goldman Sachs Group Inc. (GS) are Bove’s strongest stock recommendations due to high quality and impressive long-term outlook.

He thinks State Street Corp. (STT), PNC Financial Services Group (PNC), BB&T Corp. (BBT) and JPMorgan Chase & Co. (JPM) will have moderate increases in earnings because they ran their companies properly during the financial downturn.

Peters, on the other hand, considers the top tier bank stocks to be JPMorgan Chase and Wells Fargo (WFC), with BB&T Corp. (BBT) and U.S. Bancorp (USB) her second tier choices.

Based on Ellison’s logic that government really wants the largest banks to survive, he recommends Bank of America Corp. (BAC), Citigroup Inc. (C), JP MorganChase, Goldman Sachs and Morgan Stanley (MS) because “they have good-earning assets and in time will start to earn good money.”

Smaller banks Ellison likes include Hudson City Bancorp. (HCBK), Washington Federal Inc. (WFSL) and Astoria Financial Corp. (AF) because they have capital and “understand what’s happening” in local markets.

“Bank of America is the biggest question mark because it is heavily into retail, paid too much for Merrill Lynch and Countrywide, and had so many compensation scandals,” said Peters. “There is a lot of profitability in its model and once we start seeing some recovery in loan losses, there is going to be a large pop in its bottom line.”

While Bove sees Bank of America’s potential, he is avoiding it for now.

“It’s a consumer finance bank but its loan loss provisions are so high – having written off $48 million last year,” he said. “Unless there’s a growth case to be made for the bank I don’t want to make its stock a strong buy.”

Bank mergers are a difficult investment game.

Traditionally, a large bank buys a smaller bank at a premium, rewarding the acquired bank’s shareholders. Lately, however, banks have been purchased through the government with no premiums. That favors little banks, enabling them to buy other small banks and transform them for their market, said Ellison. Big banks don’t want the negative government attention of acquisition bids.

Andrew Leckey answers questions only through the column. Address inquiries to Andrew Leckey, 555 N. Central Ave., Suite 302, Phoenix, Ariz. 85004-1248, or by e-mail at andrewinv@aol.com.

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