Bank on This One

By Daniel Kadlec

The outlook for bank stocks couldn't be any uglier. We're a lock for higher short-term interest rates when the Fed meets March 21, and a rate boost or two after that seems likely before summer. Rising short-term rates squeeze bank profit margins and, more important, dampen loan demand. That's why bank stocks have been crashing faster than your favorite ATM, shedding 40% of their value since interest rates started climbing rapidly more than a year ago.

Which is why you should start paying attention to this beleaguered industry. Because it's not really all that beleaguered. Banks long ago learned how to hedge their interest-rate risk. So margins aren't shrinking all that much or all that fast, and loan demand remains strong, as do earnings. Fed chief Alan Greenspan cryptically alluded to budding credit problems last week when he cautioned that bad loans get made in good times. But it was just a reminder. There's nothing pervasive out there like the speculative loans tied to real estate and emerging markets that brought bank stocks to their knees in the past. Not that today's economy is without speculation. The Internet certainly fills that void. But banks aren't funding the speculation. The stock market is.

Yet bank stocks now trade below the panic levels reached during the Asia crisis in 1998. Many sport price-to-earnings ratios below 7, a low mark not widely seen in the bank sector since tough times in 1990. Simply put: Bank stocks are discounting a severe recession when it's not clear that we'll get one at all.

Why? It's partly a knee-jerk reaction to higher rates. But equally important is the massive portfolio shift from old-economy stocks to new-economy stocks that I wrote about last week. Investors are dumping anything that hasn't done well to chase high-flying tech stocks. Financial-services mutual funds are getting hit with redemptions; fund managers are selling bank stocks to pay off departing shareholders.

Tremendous value is now being created outside of the tech arena--and banks may be the most compelling. "If they're not, my family is way overinvested," quips Tom Johnson, CEO of mortgage lender Greenpoint Financial, whose stock has tumbled 60% and now carries its lowest PE ever, 7. Johnson says the whole sector carries "disaster prices" with no disaster in sight.

So why shouldn't you empty the vault and buy? You might be too early. Bank stocks will suffer until the first glimmer that the Fed plans to stop raising rates. That's when you'll want to load up. For me, part of the fun of investing is spotting great values in the making and getting ready to pounce at the right moment. Now is the time to do homework. When the bank stocks come back, they'll come back fast.

The easy play will be a bank stock fund because the whole group will move. If you're worried about missing it, start nibbling soon--but not before the next Fed hike. Stock pickers should look for banks and thrifts in growth regions like the South and West and with diverse income streams. Tom Theurkauf, analyst at Keefe Bruyette Woods, likes Washington Mutual and Fleet Boston. Scott Black, president of Delphi Management, likes North Fork and Peoples Heritage. Among larger banks, Chase and Bank of New York look attractive. But beware banks with operating difficulties, like First Union and Banc One. They won't rise with the tide. Bank on it.

See time.com/personal for more on bank stocks. E-mail Dan at [email protected] See him Tuesdays 12:45 p.m. E.T. on CNNFN