Bank stocks: Are they safe yet?

E-mail Money Magazine editor-at-large Michael Sivy at msivy@moneymail.com.

Beyond the bargain bin

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NEW YORK (Money Magazine) -- My first article for money appeared in 1980, and since then I've learned two things about the stock market.

The first is that it's easier to spot when stocks are near a bottom than when they're at a top. Investor enthusiasm seems to have no bounds when stocks are rising, but at some point declining stocks get support from the fundamental value of their underlying businesses.

The second thing I've learned is that if you're smart enough to spot bargains after any kind of market crisis, you'll almost certainly buy too soon. With a few exceptions, like the rebound immediately after the 1987 crash, crushed stocks need months to recover. Rush to buy and your money will remain stagnant - or worse, you could get hammered in a final sell-off.

The recent collapse in financial stocks, caused by the subprime mortgage crisis, will create exactly the kind of bargains that can boost your long-term returns - as long as you're patient and willing to wait for the correction to run its course.

In two similar cases, the savings and loan crisis of 1989-90 and the fallout from the 1998 implosion of the Long-Term Capital Management hedge fund, financial stocks rebounded by more than 50 percent within two years of hitting a bottom.

Once this current correction comes to an end, financial stocks will likely offer some of the best values in the market. They were cheap before, often yielding 3 percent or more in dividends.

Once the stocks finish falling, their price/earnings ratios will be even lower and their yields even higher, of course. And most important of all, they'll be less risky, since the worst of the financial sector's problems will have come to the surface.

To fine-tune your investing strategy, it helps to understand why the present crisis has come about. Soaring housing prices and low interest rates encouraged lenders to offer loans to home buyers who might not otherwise have qualified.

Wall Street found ways to repackage these riskier home loans in ways that made them appear safe, encouraging even more lending. And homeowners found that they could live beyond their means by using credit cards and then periodically refinancing their houses to pay off the card balances.

The merry-go-round couldn't continue indefinitely. This year a critical number of homeowners defaulted. It has devastated the portfolios of some hedge funds that are loaded up with mortgage-backed debt securities, and it sent some of the country's biggest mortgage lenders reeling.

And because those debt securities are so widely distributed, many money managers aren't even sure how vulnerable their holdings are. There's fear that banks and brokerages may have losses far greater than anyone expects.

As a result, financial stocks have fallen an average of 12 percent from their May highs, and some lenders, such as Countrywide Financial (CFC, Fortune 500), are down by a third or more.

Already, Countrywide has attracted the attention of Warren Buffett and received a $2 billion investment from Bank of America. But they've got strategic reasons to ally with Countrywide. You don't.

In fact, history argues that you should wait to buy financial stocks. In the previous panics of the past two decades, once the major decline in financial stocks began it lasted more than six months, and it was significantly worse than the decline of the overall market.

In the savings and loan crisis, where mortgage lenders had made large numbers of irresponsible loans, financial stocks dropped almost 50 percent over a period of 12 months. That compares with a drop of only 20 percent for the S&P 500.

The second decline has its roots in the 1997 East Asian financial crisis. Long- Term Capital Management, a hedge fund that used computers to profit from small price discrepancies between U.S. and foreign bonds, collapsed when the debt crisis disrupted bond-price patterns.

The stock market turmoil that resulted lasted for seven months. During that time financial stocks dropped 34 percent; other major market sectors lost 20 percent to 30 percent.

Once the decline is over - and as the examples above suggest, that could take several more months - you should be able to find great bargains among financials.

The best mix of risk and return will be among the higher-quality banks. They'll likely get dragged down along with the weaker stocks in the sector, but they'll have the least chance of developing crippling problems.

Stocks worth considering include Bank of America (BAC, Fortune 500) and Wells Fargo (WFC, Fortune 500), both of which are in the Sivy 70. Brokerages, which may be far more directly involved in troubled mortgage securities, will also likely be driven down to bargain levels.

For the best risk-return balance, it makes sense to avoid those with the greatest problems, such as Bear Stearns (BSC, Fortune 500), and gravitate instead to diversified giants such as Merrill Lynch (MER, Fortune 500).

And spread your risk among a variety of banks and brokerages. You could do this through a sector fund, such as Fidelity Select Financial Services (FIDSX), or through an ETF such as Financial Select Sector SPDR (XLF), Vanguard Financials (VFH) or one of the iShares Financials (IYF).

Don't worry about catching the absolute bottom in financial stocks. I prefer to miss the first few points in a rebound rather than jump in too early and see my investments sink further. Especially when history suggests patience will prove a virtue.