Three cornerstones are in place for bank stocks to do well in 1999: a healthy economy, a strong banking industry, and comparatively low bank stock valuations.

The first -the economy-is very solid.

With easier money (declining interest rates), the Federal Reserve has laid the groundwork for a strong economy in 1999. Real gross national product growth could reach 3.5%, with the second half showing the most strength, but excess spending to correct year-2000-related computer problems could modestly reduce growth.

Recent Fed rate reductions will give a kick to the economy in the second half and, together with lower global interest rates, help to reverse the slowdown in U.S. exports, which have been particularly weak. Inflation (the consumer price index), which will average 1% to 1.5% this year, will probably rise modestly, to around 2% next year, but remain historically low.

Recession is not in sight, nor is general deflation, but some prices, for example the price of oil, will show pronounced weakness.

Recent actions of the Federal Reserve suggest that it will continue to promote a stable U.S. economy and try to protect it from international shocks. Most investors know that easy money is a prescription for a healthy stock market.

Bull markets are preceded and extended by easier money policy by the Fed, and bear markets are preceded and extended by a tighter money policy. The Wall Street cliche "Don't fight the Fed" means stock prices will do well when interest rates are in a declining trend, as they have been since July 1990.

Long-term interest rates (the 30-year government bond) should stay around the current level of 5% (plus or minus 50 basis points), which implies a 3% real rate of return in line with history.

Short-term rates should also hover near current levels, with the federal funds rate up or down 50 basis points from the current 4.75% target.

The Fed did not change rates at its Dec. 22 policy meeting, as expected in an environment where the economy has been performing well. Third-quarter GDP growth was recently revised upward, to a 3.9% annual rate, and retail sales appear strong.

But in general, global interest rates are declining, and money supply (M2) is expanding rapidly. Just how much the M2 increase directly affects spending in the United States is subject to debate, as an unknown amount of our currency is siphoned off to foreign markets.

The Fed probably will reduce short-term rates next year by more than 50 basis points if inflation remains in check and the economy shows worrisome signs of weakness, if Brazil and Japan are unsuccessful at turning their economies around, or if loan spreads for lower quality commercial borrowers widen materially.

On balance, the U.S. economy will be a good place for banks to do business in 1999.

The second cornerstone-the health of U.S. banking-is excellent.

In a nutshell, the banking business is very sound. Profitability is growing nicely (better than in nonfinancial industries), and loan quality and reserves seem very acceptable. The recent historical trends for the group are dramatically positive.

For example, each of the industry's flowing profitability measures are either at or nearly at their historic highs: return on assets of 1.26%, return on common equity of 14.8%, and return on tangible common equity of 17.1%.

Capital and reserves are also near all-time highs. For example, the industry's tangible equity to assets is at 7.4%, reserves to loans are running at 1.8%, and reserves plus tangible common equity to loans is at 14.1%. Top-line revenue in banking has been growing at a compound annual rate in excess of 8% since 1991.

Meanwhile, and just as important, bankers are finding ways to dramatically increase fee income, which was up nearly 15% annualized for the first half of 1998. Bankers are also working hard to make their businesses more cost-effective and have held down growth in operating expenses to about half the rate of growth in revenues; their doing so has contributed nicely to expanded profitability. These trends will continue.

For the industry, net income grew over 18% compounded annually from 1991 to 1997 and was up 8% annualized for the first half of 1998. Earnings per share growth in 1999 will be strong again, especially compared against the S&P 500 index.

Bottom line, the banking industry will have solid operating performance next year.

The third cornerstone-the current stock valuation of U.S. banks-is very attractive. Current pricing suggests that significant upside potential exists.

The bank index composed of large regional and money-center banks (BKX) is up nominally for the year, but the broad market S&P 500 stock index is up 15%.

Banks rose in line with the market up to mid-July, then declined about 36% over the next three months when the general stock market was down. Bank stock prices have recovered much of this decline, but are not in line with overall market performance.

Viewed from another perspective, bank price-to-earnings ratios in January 1998 were about 70% of the S&P 500's own price-earnings multiple. Now they are at 63%. Meanwhile, banks' operating performance has increased faster than that of the S&P 500 during 1998.

In other words, the banks are stronger now than they were in January, but they are significantly cheaper.

Some desirable bank stocks right now are BankAmerica Corp., BankBoston Corp., Union Planters Corp., Colonial BancGroup and Prime Bancshares. Judged by valuation analysis and performance analysis (meaning that these banks are trading at a discount to the market), these companies look especially attractive.

The market and the economy should make bank stock investing very rewarding in 1999.

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