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Shortly after JPMorgan Chase (NYSE:JPM) announced an impressive $3.9 billion profit for the third quarter, an entire series of Wall Street analysts began spreading the message of hope on the popular networks: despite problems in the broader economy, banks have entered a new era of prosperity. In reality, on closer scrutiny, JPM’s performance raises two fundamental questions which traders need to answer before they make short or long calls on Wall Street’s majors:
(1) Can the revenues achieved in JPM’s investment banking business, particularly fixed-income trading, be sustained and enhanced in the forthcoming quarters?
(2) Is JPM’s potential for shareholder returns relying almost entirely on its finding a "favourable balance" between investment banking income on one hand and the need to make provisions on credit cards, consumer loans and home mortgages on the other?
And, looking beyond JPM, will the third-quarter results from Bank of America (NYSE:BAC), Citigroup (NYSE:C) and Goldman Sachs (NYSE:GS), due this week, throw up similar challenges for traders who, in specific terms, will want to address the “short-long” dilemma at current price levels?
Without doubt, JPM’s $5 billion fixed-income revenue is a consequence of both (a) its unique positioning in the financial world and (b) the friendly trading environment created by government intervention. Both factors were also critical in securing revenues from debt and equity underwriting ($1.3 billion), from advisory services ($384 million) and from a remarkable diversification in income sources ($3.9 billion from the Americas, $2.9 billion from Europe/Middle East/Africa and $740 million from the Asia/Pacific region).
However, it is important to note that “principal transactions”, i.e. revenue from realized and unrealized gains from trading activities and changes in fair value of financial instruments held, accounted for 52% of the total non-interest revenue recorded by JPM’s investment banking division. Losses on principal transactions exceeded $7 billion during the second-half of 2008. So it is logical to question if the dramatic 2009 turnaround in principal transactions ($8.15 billion-plus) can primarily be attributed to sharply improved market valuations. More importantly, what is the upside from this juncture?
Given the lack of details pertaining to maturity mismatches, one can only assume that a good portion of JPM’s fixed-income revenue has been generated by playing the yield curve in a benign interest rate environment and by profiting from the distortion in credit spreads. Will this “arbitrage” window remain open beyond the foreseeable future?
Quite clearly, any future moderation in JPM’s overall investment banking revenues will pressure loan-loss provision requirements which, in turn, are dependent, directly or indirectly, upon factors like the unemployment rate, the health of the consumer and the success (or failure) of the trial modifications for defaulting homeowners under the government-sponsored anti-foreclosure plan. JPM management has approved a total of 262,000 trial modifications thus far.
In this writer’s view, when the considerable uncertainty governing the growth, or even sustainability, of JPM’s investment banking revenues, is reviewed in the context of the need to manage delinquency ratios, the $0.82 per share third-quarter performance does not support a bullish perspective. In brief, short JPM above $47. And short Citigroup (C) above $5, BofA (BAC) above $18.50 and Goldman (GS) above $192. Unless, of course, despite extremely mixed signals, you are betting on an imminent, and decisive, economic turnaround.

The writer targets 10-20% profits on shorts before Christmas.
Disclosure: Short JPM and C.
Source: JPMorgan Dares Traders To Make Calls On Banks