Didn’t a “stress test” used to be something you saw your doctor about when life became overwhelming? Today, this buzz-phrase is more often used as a measure of American banks’ financial strength (or lack thereof).  On the surface, you might think it’s good news that several banks fared quite well and “passed” the government’s recent stress test. But dig a little deeper and you’ll find that the banks being tested actually helped set the rules.  This could be a dangerous situation for those simply following the crowd into buying banks stocks, but unaware of the real story…

Stress Test A Concoction By Banking Industry

In a nutshell, the banks’ stress test was really nothing more than a fantastic concoction put forward by the U.S. Treasury, the Federal Reserve and the banking industry.

Unemployment assumptions too high in the test? No problem… just amend them to a more favorable number.

GDP growth too low? Ah, no worries… just change it.

Hardly a surprise then that the results are unbelievable. According to the New York Times, these were the assumptions in the test:

• The U.S. economy contracts by 3.3% this year and remains almost flat in 2010.
• Housing prices fall another 22% this year.
• The worst-case scenario for unemployment has the jobless rate at 8.9% this year, rising to 10.4% in 2010.

Here are the problems with assumptions like that…

• GDP Growth: In short, we’ll see anemic expansion at best, with little evidence of the contraction ending this year. Of course, we can hope that growth will return if the government continues to spend like a drunken sailor.
• Unemployment: The April job numbers released last Friday (if you even believe them) showed that the unemployment rate is already at 8.9%. So if that’s the “worst case,” we’re now on the mend, with the rate set to decline from here, right?

I think not. We’ll see the jobless rate in the double-digits this year, not next.

• Housing Decline: This is the only part of the guidelines that makes sense. The market is finally showing signs of bottoming at levels well below expectations – something I warned readers about in late 2006.

As An Investor, Don’t Flunk This “Stress Test”

Notice how the “secret,” yet somehow highly public results were leaked at the end of last week? It worked like a charm. Investors latched onto the result, breathed a sigh of relief that financial Armageddon had been staved off, and gleefully bid up stocks. Financial shares, in particular, rallied on the news.

Funny thing is… as soon as stocks rallied – some by multiples of 100% – the same banks that claimed to be solid suddenly began to raise capital. So far, the amounts raised (and yet to be raised) are nearing the $100 billion mark.

The critics are out in force. Yesterday, Meredith Whitney (the Mark Meeker of financial shares) was adamant that she wouldn’t buy shares here. Moreover, she stated that the stress test was a joke, with banks still under-capitalized and diminished earnings power as a result of the recession and asset sales to raise cash.

So, what’s an investor to do? Are there any opportunities out there at all?

The Best Way To Buy These Three Bank Stocks

Without a doubt, there are opportunities in the banking sector.

But that opportunity is not to buy the shares today. There’s a savvier, smarter way to do it, based on the fact that bank stocks will pull back. And it’s on that pullback that you should look to buy. How?

In my opinion, the best strategy to use when buying bank stocks should be to do it through two-year LEAP options.

Why? Because these bank stocks aren’t paying you dividends these days, why risk all your capital when you can achieve better returns at a lower cost by going long with LEAPS.

However, the options are exorbitant at the moment because volatility is so high. But that doesn’t mean you’re stuck. You just need to use a high delta strategy.

Simply put, this means you should buy deep-in-the-money LEAPS in order to reduce the outlay for time and risk premium. And you should only go for the ones with the highest volatility.

In this case, set your sights on…

• Bank of America (NYSE: BAC) – when it gets back to the single digits.
• JPMorgan Chase (NYSE: JPM) – when the stock trades in the low-to-mid $20s.
• Suntrust Banks Inc. (NYSE: STI) – when shares retreat to the low teens.

However, these banks’ current prices reflect outrageous valuations, based on earnings power and economic uncertainty.

So while the black cloud may have been temporarily lifted from the banking sector, it doesn’t mean that these companies are a sure bet for profits – not at current prices anyway.

Karim Rahemtulla

Source: Bank Stocks: Disregard The Stress Test & Consider These 3 Stocks