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Why banks like Citi, Goldman and BofA will continue to lag the market

With the wave of bank earnings this week, investors in many of the nation’s largest banks including Bank of America (BAC), Citigroup (C) and JPMorgan Chase (JPM) are growing weary of chasing yield in the sector as profit growth continues to lag. Bank of America, the nation’s second largest bank, reported profits that fell 43% in the second quarter versus a year ago. Litigation costs were a large factor, jumping to $4 billion in the latest quarter, but down from $6 billion in the first quarter of the year. These legal dispute costs linger from the height of the financial crisis and continue to hamper bottom line growth.

Names like Citigroup and Goldman Sachs (GS) continue to trail the broader market, down about 5% this year, versus the Dow Jones Industrial Average (^DJI) which has gained 3% so far this year. This may be the new normal for banks for the foreseeable future, according to Gary Shilling, President of Gary Shilling & Company. He says, “[Banks] are being bereaved of the many profitable areas: proprietary trading, derivative origination, off balance sheet activities. They are being pushed back to traditional banking which is less profitable.”

While investors continue to push for stock growth in the financials, banks are hampered by factors including increased litigation costs and cumbersome regulation which prevent them from certain arenas and that makes it more difficult to make money. But Shilling says banks are trying to press their limits. "Banks are reacting to this slow-growth environment by pressing lending and they are moving out on the risk curve. The Fed and other regulators are concerned about this.”

A recent report by the Office of the Comptroller of the Currency showed that banks are easing standards and taking on more speculative activity in three key areas, including high-yield lending, indirect auto lending to car dealerships and commercial lending.

But as banks seek yield, they are returning cash to shareholders because there aren’t enough growth areas in which to invest. Shilling notes that banks want to increase their dividend. “They want to give money back to shareholders. Why is that? Because they don’t have the growth potential in terms of their stocks.”

Last week, Bank of America asked regulators to approve a dividend of $0.05 per share. B of A and many other banks have also been buying back stock as a way to return capital to stockholders. By buying back shares, the number of outstanding shares is reduced which, in turn, bolsters earnings per share because of fewer shares in the market.

This type of capital return mimics the utilities sector, a traditionally stable and defensive sector for traders. Shilling says, “The banks are viable. They’re just not going to be growth stocks. They are moving towards utility stocks.”

On whether this is a good time to invest in bank stocks, Shilling adds, "They are market performers now… there’s not great reasoning to either be extremely bearish or bullish on the banks - particularly the big banks.”

Shibani Joshi is the creator of www.ShibaniOnTech.com and can be followed on Twitter @shibanijoshi.