Bank Rally Driven by Potential Future Earnings

The SPDR Financials ETF (XLF) is up 111% since the March 6th close. The rally is being driven by potential future earnings, which are naturally speculative, but the stocks were at such extreme lows that it was not necessary to predict future earnings. At the lows, buyers only had to conclude that the companies were not going bankrupt.

At this point, the actual future earnings are becoming more important, but there could still be some long term opportunity here if earnings end up overshooting on the upside in a few years.

Consider the assumption that Bank of America (BAC) will eventually earn half of what it did in its peak year. The forward PE (unspecified amount of time) would be 4.56 in that scenario. Citigroup (C) is even more attractive using that assumption at 1.96. Granted it could take the better part of a decade, but current prices could still feasibly be fair. For example, if Citigroup figures out how to earn $15B in 2014 and the stock gets a PE raito of 10, it will go up 580% for a CAGR of about 46%.

Short term, the situation is more unpredictable as the bailout-driven Q1 reports and the FASB rule change may cause overexuberance about their ability to make money in 2009 and 2010, but this does not become "obvious" unless the index goes up another 75% or so.

Current PE - This metric is different depending on the source, so to be clear this is based on the trailing four quarters Diluted Normalized EPS as reported by Google Finance. Even the PE ratio that Google displays is often different and Bloomberg reports generally higher PEs. The earnings component seems to have different definitions, but the one that makes the most sense is how much income is attributable to the common shares.

Current PE at Peak Earnings - Imagine a world where bank earnings return to their peak levels. This is what the PE ratio would be.

Current PE at1/2 Peak Earnings - Imagine a world where bank earnings return to half their peak levels. This is what the PE ratio would be.

At Peak Earnings / Current PE - The higher, the better the company has survived the downturn so far.

At Peak * LQIP5+1 - Lower is better.