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By: Costas Bocelli — September 29, 2010

Three Banks To Avoid Right Now

AS THE SEPTEMBER RALLY TRIES TO BREAK KEY RESISTANCE LEVELS AND TACK ON MORE TO THE IMPRESSIVE 9% GAIN THIS MONTH, IT'S LEAVING THE BANKS BEHIND IN THE DUST.

Indeed this rally has been compelling, but is it more sizzle than substance? 

The recent economic data has been less than stellar -- hardly positive enough to justify a rally of this magnitude.  The action is being led by a pump priming induced stimulus, and fueled by a commodities rally and a plunging dollar. 

What’s concerning about the validity of the sustained bullish move in the stock market is that the financial sector is not only not participating in the gains, but, in most cases, seeing declines.  This is serious cause for concern if you’re looking for bullish confirmation.

Once the sizzle fades, the market will certainly look at the substance, and if the financials are not participating, this rally will most certainly fade.  The key is where and when the burners extinguish.  Perhaps it’s an escalation in the European sovereign debt crisis or the Fed disappointing the markets with not firing the printing presses on high speed.

Below is a 1 month daily chart that shows the relative strength of the S&P 500 rally against three major banks: JP Morgan (Sym: JPM), Wells Fargo (Sym: WFC), and Bank of America (SYM: BAC).

 
From the chart, you can see the SPX is up a little over 9%, while these three major banks are up less than 3%, and flat in the case of BAC.  The banks began to diverge from the SPX in the third week of September.  This is a warning sign, and it underpins what is truly behind this equity rally and confirms that you should proceed with caution if the market does indeed trade higher.

WHAT’S WRONG WITH THE BANKS?

Third quarter earnings season is about to kick off, and the banks tend to report on the early side.  JPM reports on Oct 13, which will set the tone.  BAC reports on Oct 19 and WFC reports the next day, Oct 20.

The last time they reported, in the 2nd quarter, all three beat earnings ... which you would think was positive.  However, the numbers were not beat through strong top line revenue, but rather through the usual accounting shenanigans that frustrate investors.

All three, almost in an eerily collusive way, reduced loan reserves against non performing assets, which from a GAAP standpoint directly boosts the bottom line.  Without the loan reserve reductions, the earnings would have missed.

These accounting manipulations are not taken lightly by investors.  The markets are adjusting for the fuzzy math and are discounting their own view on how non-performing assets should be accounted for.

The KBW Bank Index, in which all three of these stocks have a significant weighting, currently trades at 95% of book value, a level never seen before the credit crisis in 2008.  This is very telling that the market is discounting the banks below what they are hypothetically worth if they were liquidated today.

This is a clear indication that the markets are fully aware of the accounting manipulations.  Also, all three of these banks have heavy exposure in residential real estate loans on their books and the portfolios continue to struggle at uncomfortable levels.

Just last month, when the August numbers were released, lenders took back more homes than any other month since the US mortgage crisis surfaced 3 years ago.  CNBC reported that "one in 381 homes in the US received some sort of foreclosure-related warning in August.”  That amounts to over 300,000 households receiving the grim news in the mailbox.

The guidance from these big banks last time they reported indicates that the worst is behind us, and I hope they're right.  However, when you look at this problem on a smaller scale with a fine microscope, it may seem otherwise.  I am referring to the smaller savings and loan regional banks.

Just last Friday, the FDIC shut down two more banks, bringing the total to 127 US Bank failures year-to-date from a continued wave of loan defaults and economic stress.  These smaller banks are simply microcosms of their major counterparts.  The only real difference is the big ones are much more capitalized.  Nevertheless, the lending and banking models are similar.

The number of bank failures is expected to peak this year and surpass the 140 that fell in 2009.  The number of “problem” banks on the FDIC’s list jumped to 829 in the second quarter from 775 in the prior three months.  When these companies report, it will be very telling how they address loan reserves in this quarter.

Another strain on earnings will come from a profit squeeze from the flattening yield curve.  The 10 year treasury yields have been below 3% for the majority of the 3rd quarter.  Today, it sits at 2.50%.  Mortgage rates have come down to record levels with a 30 year fixed below 4.50%.  New loans originated or refinancing out of higher interest rate loans reduces the spread these banks collect.  The Fed is focused on keeping mortgage rates very low, which is a double edged sword that must be dealt with.

The major banks also derive a significant portion of their revenue from investment banking and trading.  The third quarter has seen a significant reduction in trading volume across the board, and this will affect top line revenue.  Global stock underwriting proceeds have slipped 9 percent so far in 2010, which will particularly affect JPM and BAC.  Hiring in the investment banking and trading divisions have been frozen, and some have seen reductions.  This is a confirmation that the slowdown in activity will affect earnings for the remainder of the year.

If the market does reverse and fall back into the trading range, the financials will perform poorly, as they are one of the weakest sectors.  JPM, WFC, and BAC could easily test or break their August lows.  If the market does break this resistance level and makes a run to the April highs, follow the sizzle.  Commodities will most likely continue to lead the market higher, far outpacing the struggling financial sector. 

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