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Avoid Banks Like the Plague, Buy Tech

Written By Brian Hicks

Posted October 18, 2010

At dinner parties, I generally avoid talking finance.

America’s looming funding crisis doesn’t make for good small talk — according to my wife, anyway…

Apparently the sheeple would rather shove their fingers in their ears and chant nah nah nah.

But this past Saturday, we were at a friend’s house for dinner in Bethesda. The typical D.C. business crowd was chatting over drinks when I heard someone talking about how cheap bank stocks are…

I probably should have kept my mouth shut, but I couldn’t resist.

The bank-bull turned out to be a young broker from a big investment firm. When I joined the conversation, he was explaining to the group how cheap Bank of America (BAC) stock is.

“BAC is a $25 stock,” he told the circle of D.C. suburb-dwellers. The fact that it’s trading at $12 means it’s a bargain, obviously.

“What happens if banks are forced to use mark-to-market accounting? What about that big subprime portfolio?” I asked.

Deer, meet headlights.

It was clear he had no idea what I was talking about.

I brushed off my questions as insignificant accounting stuff, and changed the topic to something easy: football.

(My wife breathed a sigh of relief.)

He turned out to be a decent guy, and we had a nice chat about recent NFL action. He was a Patriots fan, and I was willing to overlook that.

The thing that bothered me was his bullishness on bank stocks, combined with the fact that he knew zilch about shady accounting practices and loan books.

Who knows, Bank of America may be a good deal at these levels… But that’s not the point.

The point is that we don’t know, really.

U.S. banks are a big fat unknown.

And I’m fairly certain one of the first lessons in Investing 101 is don’t buy what you don’t (and can’t) understand.

potted mystery meat“Mystery Meat” balance sheets

Buying U.S. bank stocks is sort of like buying a gyro from a street vendor.

There’s no way to tell what you’re getting.

“Exactly what kind of meat is this, sir?”

“It’s just meat; it’s good” he assures you, nodding and grinning.

That’s about as much clarity you’ll get on bank books these days.

Changes to accounting rules have made balance sheets in the sector a farce. Like the change that allows banks to value holdings at what they say they’re worth, rather than what somebody would actually pay for it.

It’s known as mark-to-imagination accounting. That’s opposed to mark-to-market accounting, in which securities are valued based on what people will actually pay for them.

These accounting changes were supposed to be temporary, but like Milton Friedman said, “Nothing is so permanent as a temporary government program.”

So the game is extend and pretend.

It can’t last forever, of course, which is why I’m steering clear of bank stocks.

Now don’t get me wrong — banking is a good business to be in. You borrow money at 0% (thanks, Ben!), buy t-bonds that pay 3%, do some lending at 5%, and charge 25% APRs on credit cards.

But once you pay all those huge bonuses — and factor in uncertainty over future losses — it’s unclear how profitable these banks really are.

There are simply too many unknowns.

Example: JP Morgan Chase just set aside $1 billion in reserves for bad loans it sold to Freddie Mac and Fannie Mae. Now that the loans are going sour, the bank is obligated to buy them back from the government.

This and other issues — like Foreclosuregate — will continue to plague U.S. banks.

I’m steering clear of the financial sector altogether. I don’t want to be short, but I sure as hell don’t want to be long.

The tech oasis

Spend an hour trying to dissect a bank balance sheet, and you should have new appreciation for companies with clean books…

Companies like Google, which we’ve been pounding the table on for months now. They knocked the cover off the ball last Thursday with a strong earnings report. The stock closed up 11% Friday, and is up another 2% today.

It’s a business investors can understand: Transparent accounting; $100/share of cash on the books; the company is growing revenue more than 20% annually.

Zero debt, great technology, reasonable valuation.

Why would anyone speculate on bank stocks with alternatives like GOOG out there?

It’s baffling.

Hard assets: Another oasis

If tech isn’t your thing, precious metals and commodities remain great alternatives. Gold and commodity stocks should continue to outperform over the next five to ten years.

Getting exposure to gold miners has never been easier. You can buy GDXJ, the junior miner ETF. It’s an easy way to own a diversified basket of small gold mining companies.

Hard assets of all sorts should do well in the coming currency wars, as the Fed and other central banks try to out-print each other in order to support zombie banks, devalue currency, and boost exports.

Good investing,

Adam Sharp
Analyst, Wealth Daily