Larry Cohn admits the bearish view of bank stocks he took in late 1994 was wrong in several ways - but he still expects to be right.
Banks over the past year kept a far tighter lid on expenses and held off rebuilding loan-loss reserves much longer than the veteran analyst at PaineWebber Inc. imagined they could.
These positive factors boosted most banks' earnings and stock prices, he readily acknowledges. At some point, however, Mr. Cohn feels, the bill for these actions will arrive.
"I have absolutely been surprised at how well the industry has done in controlling expenses," the analyst said in a recent interview.
"But it is not at all clear to me how long the banks can keep it up. The real issue is the long-term cost of doing this," he said.
"What will be the effect of not having made investments in capacity and people that you should have made? It is something that does not show up in the short term, but will certainly emerge over time."
He sees a more immediate problem in the deferred replenishment of some banks' loan-loss reserves, even as credit problems have begun to rise and banking revenues have slowed.
"We're seeing more banks using up their excess reserves," he said. "As a result, (quarterly) loan-loss provisions are rising rapidly. If revenue growth is slow and you have to give some of it away, to cover a provision, then things get tough."
Mr. Cohn saw unsettling signs in the industry's first-quarter earnings results: good numbers, but much window dressing.
"The earnings themselves were as expected, but the quality of the earnings was a different matter," he said "When you started looking inside, there was a lot of nonrecurring stuff, and people ultimately see through this."
The best example was BankAmerica Corp., he said. "If you have a gain on the sale of a subsidiary, or take a large amount of investment securities gains, as they did, those are not earnings the market tends to capitalize." And the stock's performance has "stalled out."
But Mr. Cohn expressed frustration that the stock market this year has generally not distinguished between banks that have maintained reserves and produced good quality earnings, and those that have not.
He suspects that the record-shattering amount of liquidity that has poured into the market this year, principally through equity mutual funds, has played a role.
The analyst said that in the quarters ahead, he expects further dampening of bank earnings expectations as consumer loan chargeoffs keep rising. "Our view is that nothing in the world is going to stop that," he said.
Mr. Cohn's bank stock investing strategy right now is to stay "mostly on the sidelines." He currently recommends shares of only three banks: J.P. Morgan & Co., Bankers Trust New York Corp., and Bank of Boston Corp.
The outlook for bank stock is clouded by the "soft landing" that seems to be under way in the economy, as the PaineWebber analyst sees it.
A soft landing occurs when the Federal Reserve manages to reduce the economy's growth rate and quell inflationary expectations without causing a recession. Some economists think the Fed has never before successfully pulled off this feat.
"This is a brand-new event for bank stock investors," pointed out Mr. Cohn. "If the economy just doodles back and forth, growing only a couple of percent a year, it's hard to get excited about bank stocks."
What could change his outlook? A healthy acceleration in economic growth could lift the demand for loans, increase incomes, improve consumer credit quality, and make the stocks look cheap against better earnings prospects.
"You can't say it won't happen, but we think it's very unlikely in the fifth year of an economic recovery with full employment," the analyst said.
"If the market sells them off, there will be opportunities," he said. "Otherwise, we are looking at a group of stocks that is pretty fairly valued right now."
And while Mr. Cohn sees banks' stocks going nowhere special, worries about reserves, and views expense control as a doubled-edged factor, he does see one unqualified bright spot for banks.
"The industry has done a far, far better job in dealing with excess capital than its history would have ever led you to believe possible," he said.
"There have been a few acquisitions at big prices. But by and large, so far, and unlike the last credit cycle," he said, "the industry has so far not wasted its excess capital by chasing risky loans and leveraging up balance sheets.
The big difference from past cycles is the debut of bank stock buybacks, which were once frowned on by regulators but are now used routinely by banks as a capital management tool.
"To the extent the banking industry has shown discipline and buys in its excess capital, it has removed the temptation of making dumb loans," Mr. Cohn said. "This is a sea change and a clear-cut positive." Mr. Cohn worries about the long-term costs of controlling expenses.