With economists and bond traders at odds on the direction of interest rates, bank stock investors may need to reevaluate their strategy.

Rates really don't control bank earnings, Wall Street analysts insist, but the stock market stubbornly believes otherwise.

And viewed through the prism of rates, bank stocks right now are fully valued, according to several industry watchers.

"With a 7% long bond, bank stocks are fairly valued versus their history and are likely for now to trade in line with the bond market," said Carole S. Berger of Salomon Brothers Inc.

The only factor that could change that would be a significant improvement in banks' return on equity. Ms. Berger and other analysts at Salomon expect returns to stay about where they are now.

Indeed, she said, the aggregate return from banks has been extraordinarily constant for decades at the 15% to 16% level - outside of several sharp breaks in the credit cycle.

Historically, Ms. Berger said, the earnings yield of the major banks followed by Salomon Brothers has averaged around 110% of the rate on the 30-year Treasury bond, better known as the long bond.

The earnings yield is the inverse of the price-to-earnings ratio. That is, it is calculated by dividing a bank's earnings by its price. Against the long bond, it can be viewed as a risk premium.

In the first quarter, Salomon's 50-bank universe remained relatively inexpensive, with an earnings yield at 123% of the long bond's 6.4% average rate, she said.

Since then, however, the long bond's rate has moved up to the 7% vicinity, reducing the risk premium to around 112%, or roughly average, Ms. Berger noted. In short, bank stocks are at full value.

That is what largely accounts for investors' tendency to view bank stock values in relation to bond prices. If it's otherwise stable, the earnings yield on banks falls when rates are rising and rises when rates are dropping.

For bank stocks to perform well from this point, then, rates must fall. If they rise further, banks could slip in value.

Unfortunately, the direction of rates is murky, as signaled last week by a Dow Jones survey of primary dealers in Treasury securities. It found 19 dealers looking for a rate hike as the next move by the Federal Reserve, while 17 dealers thought the Fed's next move would be a further easing of credit.

Economists also are divided, as noted by the latest American Banker yield and rate survey. (See related story on this page.)

While she tracks the impact of rates on bank stock valuations, Ms. Berger agrees with other analysts that rate movements are much exaggerated as an influence on bank earnings.

"Rates are an issue related to returns but not to earnings," she emphasized in an interview last week.

Among the most forceful opinions against this misperception is one offered by Richard X. Bove, bank stock analyst at Raymond James & Associates, St. Petersburg, Fla., in a report titled "Rethinking Banking Dogma."

"The single-minded focus on the interest rate impact on banking is simply irrational, and cannot be proven," he asserted. "In the past 50 years, rate changes have almost never been a critical variable in bank earnings."

More importantly, "Overconcentration on rates is causing investors to ignore the significant changes that have restructured the banking industry."

The analyst said he believes bank stocks now trade in line with rate movements "solely because in the past five years bank earnings went up as rates came down."

In fact, the events of the 1980s that sparked this pattern were an aberration when viewed in historical context, he said. "Simply stated, the record of the industry from 1979 to 1991 was just awful."

But Mr. Bove blames this bad period mostly on the dramatic reduction in inflation, not on new competitors or bad bank management.

Actually, the analyst said, he believes bankers and their regulators were excellent managers, avoiding "a financial disaster that would have plunged the United States into a multiyear depression."

Banks have since returned to robust good health, and Mr. Bove sees that as the key to breaking the market's habit of viewing bank stocks as captive to moves in rates.

He said he expects large banks' earnings to do well even as interest rates continue to fluctuate. This should cause "continued increases in real bank equity, which we believe drives bank stock (price-earnings) multiples higher."

And ultimately, he is confident, "there will be a delinking" of bank stock prices from interest rates.

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