Bank stocks rally! Great selling opportunity!

Mike here with a quick update on the so-called “big rally” in bank stocks this week.

Yes, their shares have soared for the last two days.

And yes, Wall Street is cheering.

But if you’re wondering whether this is a time to jump back in …

My answer is a flat, unabashed “NO!“

Reason: The massive exposure most banks have to souring assets has just begun to be revealed. Nothing has changed. And the rally you’ve seen this week is minuscule in contrast to the huge declines we’ve seen over the past 18 months.

The KBW Bank Index, for example, representing a basket of 24 banks, reached a peak of 121.16 in February of last year. But now take a cold hard look at where it stands:

• Even after two days of dramatic rally, this all-important index still closed last night at 62.19, down a whopping 48.7% from its February peak.

• The index is still trading BELOW its bear market low of 2002.

• The index also busted through the lows corresponding to the depths of the Long Term Capital Management crisis in 1998.

• Indeed, the KBW Bank Index erased every penny of gains going back to October 1996!

So after all that damage and carnage, what we’re seeing now is little more than an ordinary, short-term rally — a major selling opportunity for investors still stuck in U.S. bank stocks.

Among the most vulnerable right now: The regional and super-regional banks. Just look at what’s happening in this group …

• Buffalo’s M&T Bank has announced a $100 million loan loss provision, more than triple the $30 million of a year earlier. Net charge-offs of bad debt surged to $99 million from $22 million. Second quarter profits dropped 25% year-over-year, widely missing its estimates.

• Cleveland’s National City lost $171 million in the first quarter, a huge swing from its year-earlier profit of $319 million. The company had to offer big enticements to investors in order to raise $7 billion in capital earlier this year. And even that large infusion is not likely to be enough.

• Both Washington Mutual and Wachovia were also forced to issue statements pointing out their capital status and liquidity in the past few days after their share prices tanked. The problem: The companies have hundreds of billions of dollars in mortgage exposure, with a disproportionate share of that exposure in states that are getting hit the hardest.

No, not all banks are in bad shape. I never said they were. But two days of rally will not end the credit crisis … will not end the massive losses … and will not reverse the banks’ long, sickening slide into the red.

The Threat of Failure

Already, we have seen IndyMac taken over by regulators. With assets of $32 billion as of March 31, it was the second-largest institution to go down in U.S. history. Resolving the failure won’t be cheap, either. The FDIC estimates the cost at anywhere from $4 billion to $8 billion.

If capital market conditions continue to deteriorate and loan losses continue to rise sharply — as I expect they will — we’re going to see more large failures over the next two years.

Bank share prices will be crushed.

Uninsured depositors could lose a large portion of their money.

And even insured depositors would be better off doing business with strong banks (of which there are still quite a few to choose from).

Stay tuned for specific instructions on how to find them and even how to turn this crisis into a major profit opportunity. But for now, I would continue to avoid investing in this sector.

Until next time,

Mike

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