Will big bank stocks keep up their big run in 2013?

After great returns last yet, a number of big headlines are shaking up the financial sector in the New Year.

By InvestorPlace Jan 9, 2013 12:51PM
IPLOGOBank sign John Foxx Stockbyte Getty ImagesBy Jeff Reeves

Bank stocks put on quite a show last year. JPMorgan Chase (JPM) added 34% vs. 16% for the S&P 500. Citigroup (C) was up 56%. Bank of America (BAC) shot up 116%.

So ... will it last?

At first blush, I was inclined to count out bank stocks in the New Year. But a closer look shows a more conflicting narrative for the financial sector. There are as many reasons -- perhaps more -- to bet on bank stocks as there are to bet against them. Take a look:

In favor of bank stocks
Sector has momentum: Bespoke Investment Group shows that when it comes to sectors, financials are leading the way -- at least in the rear view. Relative strength of the 10 S&P sectors strongly favors bank stocks, followed by consumer discretionary plays. Just look at the outperformance of the Financial Select Sector SPDR (XLF) in both the short- and long-term for proof.

Capital requirements easing: The Basel Committee -- as in Basel liquidity requirements for global banking companies -- announced an unexpected easing of rules in the past week. The gist is that banks can use a wider variety of assets towards satisfying capital requirements -- a crucial buffer akin to a savings account or a rainy-day fund. If you'll recall, the reason the financial crisis came about is because banks overreached on highly leveraged bets without adequate capital to back them up if they went south. A big cause of uncertainty has been regulations limiting how much risk financial corporations can take on and how big of a cash cushion they have to keep in reserve, so any movement toward flexibility or looser capital requirements is a welcome sign.

Big legal settlements: Financial stocks finally are done with some of the big regulatory and legal overhangs caused by the mortgage crisis. The nation's biggest banks agreed this week to $19 billion in settlements -- and while that number is big, it is at least a signal that some of these disputes are finally over and done with and investors can move on. The settlements included Bank of America paying $8.5 to Fannie Mae over toxic Countrywide mortgages it passed on, and then a 10-bank deal including Wells Fargo (WFC), JPMorgan, BofA and others to provide billions to borrowers over unscrupulous foreclosure practices.

Housing turnaround and recovery hopes in 2013: A big reason for the rally in bank stocks last year was improvement with housing, and thus with mortgage businesses. That momentum in housing continues, with November home sales and prices rising again. Continued strength in core lending that includes mortgages will not only boost earnings per share for banks, but provide some faith in a revenue stream that many investors remain very skeptical about.

Risks to bank stocks
All that said, things aren't 100% rosy. There are real risks to the financial sector going forward:

Who knows? Despite the fallout of the financial crisis and a push for greater transparency and regulation, many investors and even top government officials have no idea what the risks are to banks. Why else do banks trade at such low valuations relative to their book value and earnings if not for a lack of trust in the numbers? According to The Atlantic, a recent survey by Barclays Capital found that more than half of institutional investors did not trust how banks measure the riskiness of their assets. If this is the "smart money," what shot do retail investors have at actually understanding the facts and the real risks?

Regulations aren't all gone: While the Basel news is good, proprietary trading rules could severely limit revenue. Remember the London Whale and the multibillion-dollar trading loss at JPM less than a year ago? Yeah, that didn't help banks convince regulators that consumer banking companies like JPMorgan should be allowed to gamble with deposits as they see fit. Some financial analysts estimate that prop trading limits could hamstring revenue by as much as 20% at big banks that are reliant on trading desks.

Outlook ain't grand: Analysts are offering pretty tepid 2013 earnings outlooks for banks amid low interest rates that will persist as well as the aforementioned trading limits. Furthermore, the "growth" we could see might just be a shell game as banks release loan loss reserves. A trick of accounting allows banks to take money out of their rainy-day fund and apply it to the bottom line -- but accounting tricks due to overall improvement in the credit quality of loan portfolios is not sustainable and cannot prop up the bottom line forever.

Overbought? The sentiment-driven nature of the market these days means banks have largely been in favor as a group … and will largely fall out of favor as a group once investors find a new fad. Steve Sosnick, an equity risk manager at Timber Hill, said in a Dow Jones interview that, "I think it's a momentum trade, not really a fundamental trade." That just about sums it up. As long as sentiment is good, the rally may continue ... but I remain skeptical. It seems likely that investors will take their profits and move on sooner rather than later.

What do you think? Share your thoughts on banking stocks and the outlook for the financial sector below.

Related reading
  • David Weidner, one of the best bank stock watchdogs in the biz, weighs in on why the Basel rules need to be tougher -- not weaker. (MarketWatch)
  • Philip van Doorn over at The Street is another great banking industry analyst. And he points to some relatively unknown bank stocks that "can't stop posting profits" that you should definitely check out. Bank of the Ozarks (OZRK), anyone? (The Street)
  • Frank Partnoy and Jesse Eisinger do a bang-up job summarizing the uncertainty at banks despite all the daylight between now and 2008. (The Atlantic)
Jeff Reeves is the editor of InvestorPlace.com and the author of "The Frugal Investor's Guide to Finding Great Stocks." Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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