The safest bets in bank stocks

(Money Magazine) -- Since March, bank stocks have staged a remarkable turnaround. In just eight months the financial sector of the S&P 500, which was battered in last year's credit storm, has soared 132%

And shares of some of the biggest banks in the group have done considerably better. Bank of America and Citigroup, for instance, are up fourfold (though both are still down more than 70% from their peaks).

So you may be wondering if these stocks -- which have traditionally been considered core holdings in retirement portfolios, thanks to their once-reliable earnings and dividends -- are healthy enough to trust again.

Such optimism is premature, warns Frederick Cannon, chief equity strategist for Keefe Bruyette & Woods. When it comes to bank profits, for instance, "we're not going back to the way it was in 2006 and 2007," he says.

This is especially true now that the risky, leveraged strategies banks relied on in the past have been discredited and government regulations are on the way.

That's not to say you should forgo these stocks altogether. But you have to be mindful of the risks.

While financial companies appear to be healthier than they were at the start of the year, thanks to a stabilizing housing market and taxpayer bailout funds, they're not out of the woods.

Some still have hundreds of billions of dollars in risky loans on their books. In fact, $642 billion in large commercial loans is in danger of souring, according to the federal government. That's substantially more than was at risk in 2008, at the height of the credit crisis. And even if these loans don't go bad, their value will probably fall, especially if market interest rates rise, says Cannon.

Adding to the sector's stress is the health of the commercial real estate market. As office-building owners are likely to need to refinance in droves between now and 2012, many will find their property values have dropped too much to make that possible, says Charles de Vaulx, portfolio manager for IVA Funds.

That, plus rising vacancy rates, could lead to another wave of defaults, which could further threaten bank finances, he says.

Just as bank balance sheets aren't as healthy as they seem, sector profits aren't as promising as you think.

Take the third quarter. Financial earnings are expected to rocket 98%, a big reason investors have been so bullish on this group of late. But subtracting out the results of just one company -- the insurer AIG (AIG, Fortune 500), which lost $10 billion a year ago -- analysts forecast profits to fall 18%, according to Thomson Reuters.

Yet "the market is acting as if there will continue to be good news," says Bob Doll, global chief investment officer of equities for BlackRock. The price/earnings ratio for financial stocks is 21, based on future estimated earnings, compared with 17 for the S&P 500.

Are such lofty valuations for the sector justified? Probably not, considering that in a more regulated world, banks will have to go back to earning money the old-fashioned way: "By borrowing at 3%, lending at 6%, and getting their money back," says David Ellison, president of FBR Equity Funds.

In May, Money warned against indiscriminately buying bank shares. That advice still holds true today. But a few opportunities may be starting to present themselves:

Megabanks. Size is no longer working to this group's advantage. Bank of America (BAC, Fortune 500), for instance, saw rising problems on both its commercial real estate and consumer loans this quarter, as the bank posted a $2 billion loss. Meanwhile Citigroup (C, Fortune 500) is trying to break in two. But Morningstar analyst Jaime Peters says Citi doesn't have the capital to spin off its less desirable assets.

By comparison, J.P. Morgan Chase (JPM, Fortune 500) looks reasonably healthy, notes Edward Jones analyst Shannon Stemm. J.P. Morgan used its acquisition of Bear Stearns to beef up its asset-management business, which is already benefiting from the rebounding market. In the third quarter, income from that division grew 23%. Even better, the stock trades at a P/E ratio of just 13.

Retail banks. The health of regional banks is largely dependent on consumers in their key markets. Fifth Third Bancorp (FITB, Fortune 500), for instance, saw losses widen due to real estate woes in Michigan and Florida.

Among the national players, it's a mixed bag. Wells Fargo (WFC, Fortune 500) faces credit strain owing to its exposure to high-risk mortgage loans like option ARMs, notes Deutsche Bank's Matt O'Connor. But the conservative underwriting practices at U.S. Bancorp (USB, Fortune 500) are resulting in lower charge-offs than its peers', says Morningstar's Peters. Plus, its earnings are buttressed by two fee-based businesses: credit card processing and wealth management.

Investment banks. The two surviving investment banks, Goldman Sachs (GS, Fortune 500) and Morgan Stanley (MS, Fortune 500) -- which are technically bank holding companies - were healthy enough to repay their government bailout funds recently. And both will benefit now that stocks and mergers and acquisitions are picking up.

But Goldman has a much stronger balance sheet, says UBS analyst Glenn Schorr. Plus, it was never forced to drastically reduce its dividends as other banks were.

If you prefer to invest through a fund, stick with one willing to be selective, given the risks that remain. A good, low-cost example: T. Rowe Price Financial Services (PRISX).