In late February, early March, a debate developed concerning what factors actually drive bank stock prices. The vast majority in that debate argued that an increase in interest rates, positive stress tests, high levels of stock buybacks, easing banking regulations, and a strong bull market would continue to drive bank stock prices higher.

On the other side, a very small minority, including myself, argued forcefully that these factors were not the key to bank stock prices. The rally in these issues was over. The key would be the sale of high quality products. Translating this means that banks needed to sell more loans and those loans could not go bad.

Both sides in this argument obtained what they wanted. Every promise the bulls made about banking came true. My assumptions also came true. Loan volume continued to weaken and loan quality began to deteriorate.

The market made its judgment. Five of the six largest bank stocks fell in price from March 1 to the present. The XLF which monitors the price action of big financial institutions is down slightly or 1.9 percent. The KBW Nasdaq Bank Index, BKX which is a large index covering many more bank stocks, is down somewhat more or 5.6 percent. The S&P 500 is up 4.4 percent. The broader bank index has under performed the market by 10.0 percent.

So why were the banking bulls, to this point, so wrong?

Start with their view on interest rates; it simply made no sense. They argued that banks cannot make money when interest rates are low for long periods and that bank interest rate margins would be up sharply if the Fed raised rates. Yet from 2010 to 2016, interest rates were the lowest in recorded history and bank earnings went up in all but one of those years. Bank profits were at all-time record levels in 2013, 2015 and 2016.

Further, 92.5 percent of bank assets are financial instruments and the FDIC-Insured banking industry holds $3.5 trillion in securities. They are big bond funds and the bank bulls are arguing that they would benefit by raising interest rates.

Next, interest rates are the cost of money to banks as well as the price on the products they sell. The bank bulls ignored this. Yet from December 2015 to the present the effective Federal Funds rate is up 90 basis points and the net interest margin of the banking industry is up 10 basis points. This reality is totally contrary to what the bank bulls predicted.

Next, the bank bulls are committed to the belief that buying back stock drives up bank stock prices. I actually asked a half dozen banks whether they had completed any studies to prove this assertion. Not one had, or more correctly, not one was willing to share this information with me. Yet, they were following the demands of the bank bulls, in my view, blindly.

Stock buybacks are done for financial engineering purposes. The reality for banks is that capital is the core source of bank earnings. It is the basis of leveraging the bank balance sheet and making loans. If a bank reduces capital it lowers its ability to earn money; weakens its secular growth prospects. Why would anyone want to buy a company which is lowering its growth potential to play “stock market?”

Also, even though there is likely to be some easing in bank regulations, this is not key to results. At the moment, living under draconian regulations, which have effectively nationalized the banking industry, banks keep reporting record earnings as noted above.

At the most basic level, it is clear when evaluating any company the first issue is “How are sales?” “Are you selling your products?” For some odd reason, no one want to ask banks that question. Yet banks are like every other company. They have specific products – most importantly loans and capital market offerings.

They have to sell these products to grow earnings. In the past year, this has not been a positive development. Virtually every product they sell is either not selling or selling at a much slower rate than a year ago. This includes commercial and industrial loans, residential real estate loans, consumer loans, and even non-residential real estate loans. Trading stocks has not been great, and investment banking is slowing. Why should I or anyone else buy into a slowing sales cycle?

Plus, it is very important that the products that banks sell be of the highest quality. They are no longer in that category; bad loans are creeping up.

Bottom line, all the financial gimmickry and false hypothesizing in the world is not going to offset the very real fact that banks need to sell more products to bolster their stock prices. One hopes that they will do this. If they do then it will be time to buy these stocks.

Commentary by Richard X. Bove, an equity research analyst at the Vertical Group and the author of “Guardians of Prosperity: Why America Needs Big Banks” (2013).

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