Bank-StocksBank stocks have been one of the strongest sectors in the market over the past year. Bank stocks have rallied sharply after many investors dumped shares on fears that the financial crisis might worsen. Those fears obviously never materialized, and many bank stocks have begun to resume paying dividends and generating profits.

There are two questions I am often asked: 1) is it too late to incorporate bank stocks into one’s investment strategy; and 2) if someone has already owned bank stocks over the past couple of years, is this the time for that investor to start taking profits?

Since the fall of 2011, an index of bank stocks has almost doubled in value. Clearly, an investment strategy that owns a number of bank stocks has seen significant gains in this sector. But no one can rationally expect this type of return to continue forever.

Part of my cautious view on bank stocks, in terms of reducing the sector weighting in an investment strategy, is the fact that there is a limit to upside capital appreciation in every sector. A big question when developing an investment strategy: what is the future outlook for the sector?

Obviously, the low-hanging fruit has already been picked when it comes to bank stocks. Regardless of what was thought about bank stocks in the past, as an investor you are only interested in the potential for growth in earnings and revenues. Large gains have already been realized; now we need to consider how bank stocks fit into an investment strategy over the next decade.

Large concerns for bank stocks shareholders are increased regulation and a reduction in potentially profitable areas of business. The president of the Federal Reserve of Philadelphia, Charles Plosser, stated that there needs to be an increase in effort to ending the problem of “too big to fail” banks. (Source: Spicer, J., “Fed’s Plosser adds voice to too-big-to-fail criticisms,” Reuters, May 9, 2013, accessed May 10, 2013.)

One of the measures that Plosser has endorsed is for higher levels of capital to be held by the bank stocks. There are suggestions of breaking up the bank stocks completely, as well as lower borrowing limits. In a nutshell, if one were a shareholder in bank stocks, the thesis behind this investment strategy might be in doubt, as the landscape looks increasingly hostile toward the sector. Many of these measures will ultimately end up limiting the growth potential and profitability of bank stocks.

Featured below is a chart for the bank stocks index:

This chart of the bank stocks index shows just how strong this sector has performed over the past couple of years. While there are negative implications from the increased regulation for bank stocks, many investors are incorporating a strong dividend yield issued by these companies into their investment strategy.

This ends up being a battle between fundamental and income investors. Income investors will continue to search for yield, which involves many bank stocks, while investors looking at valuations and the potential for future earnings might begin to take profits in bank stocks, as the heavy hand of regulation appears to be headed toward the sector.

It is clear from looking at the above chart that the uptrend is still intact. No one can predict when a top will occur, but what we can do is reallocate resources into more attractive areas. The real question: what is the best way to build a long-term investment strategy? One can determine that by looking at his or her portfolio and individual goals.

While bank stocks are not going away, the uncertainty about the viability of earnings growth and recent outperformance in the share price certainly raises doubts in my mind as to the potential for capital appreciation. At this point, I would certainly look to reduce my exposure to bank stocks ahead of any new rules being implemented in this sector.

This article Is It Time to Book Profits in Bank Stocks? was originally published at Investment Contrarians