Financials are "a value trap," warns Richard Bernstein, chief investment strategist at Merrill Lynch & Co. Financial stocks appear attractive because of low valuations, but they will continue to falter as earnings stall and more lenders fail.
As that happens, financials' valuations will fall even more, he wrote in his Investment Strategy Update.
The current business cycle most resembles the 1989-1990 cycle when financials proved to be terrible value traps, says Bernstein.
"Value investors were lured to the stocks' valuations, but substantial underperformance ensued," he writes.
"Each time the stocks underperformed, value managers bought more, and the underperformance eventually got so severe that some long-only value managers lost substantial assets under management or even went out of business."
About 25 percent of financial institutions disappeared through mergers, acquisitions and bankruptcies in the 1989-1990 cycle. Based on that pattern, Bernstein predicts about 260 banks and thrifts will fail now.
Even the FDIC is preparing for more failures, Bernstein notes. It's beefing up its bank examiner force and\, drawing some examiners out of retirement.
"I'm not so sure investors are aware of this," he told Bloomberg News.
Don't jump into financials until the government provides a systemic solution to the credit crisis, Bernstein advises.
"Until that happens, credit market operations will remain hampered by lenders' fears of being inadequately compensated for risk taking."
For now, government action has amounted to one-off responses to each major problem, he says. Instead of addressing the financial sector's severe overcapacity, it has sought to maintain the status quo.
History shows the error of that approach. Japan prolonged its financial crisis by attempting to keep the status quo. However, Sweden shortened its crisis by forcing financial sector consolidation, he says.
Within a couple of weeks after his writing, the S&P 500 financial index jumped 26 percent.
"Investors are playing into a value trap," Bernstein told Bloomberg.
Massive consolidation is needed for the financial sector to recover, says Bernstein. And a return of credit is needed for the housing market and the stock market to recover, he says.
"It's hard for the stock market to bottom out and form a major bull market without credit conditions easing. Clearly credit conditions are not easing just yet."
© 2017 Newsmax. All rights reserved.