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The Financial Select Sector SPDR (NYSEARCA:XLF) presents an interesting investment scenario in the current market environment. On one hand, we have the recent announcement of QE3 which should (in theory) prop-up the financial institutions. On the other hand, we have the looming fiscal cliff, which if left untreated could push the U.S. economy into a recession in 2013.

(click to enlarge)

Under the government's QE3 program, $40 billion per month will be used to purchase mortgage-backed securities. The Fed has a goal of keeping interest rates low until at least mid-2015. This injection of money should keep the banks humming along if similar results of past QE efforts repeat again this time. The outcome of QE1 and QE2 resulted in a rising stock market despite the stubbornly high unemployment rate.

The XLF has risen from under $10 following the financial crisis to its current price of $15. However, it hit $15 in 2009 and has traded around that level ever since. The banks and the XLF have not fully participated in the bull market of the past few years as they have lagged the S&P 500. This has kept the valuation of the banks on the low end of undervalued.

It looks like the reality of QE for the banks has resulted in keeping them afloat rather than propelling them to great heights. Therefore, this third round of QE won't necessarily be a great catalyst for the XLF, but it will most likely keep it humming along sideways while it pays a dividend of 1.71% (assuming all other variables remain constant). However, I think there are other variables that will propel the XLF higher, which will be explained later.

The fiscal cliff refers to the predicted reduction in the budget deficit resulting in an economic slowdown if certain tax laws are allowed to expire at the beginning of 2013. If the tax laws were allowed to expire, the banks would most likely take a hit as the economy would enter a recession. This scenario would take the XLF to below $10 representing at least a 33% price drop. However, it is doubtful that nothing would be done to extend some or all of the tax laws in question given those repercussions.

I think it is important to look at the major components of the XLF to further delve into its investment risk/reward. Here are the XLF's top five holdings:

Wells Fargo (NYSE:WFC)

Berkshire Class B (NYSE:BRK.B)

JPMorgan

(NYSE:JPM)

Citigroup (NYSE:C)

Bank of America (NYSE:BAC)

Dividend

2.5%

None

3%

0.10%

0.40%

Forward PE ratio

9.5

15.5

7.82

7.28

9.86

PEG ratio

1.22

1.27

1.25

0.77

2.04

Price/Book

1.32

1.23

0.83

0.52

0.44

Operating Cash Flow

$20.48 B

$20 B

$83.46 B

$41.21 B

$16.04 B

Total Cash

$154.63 B

$40.66 B

$850.75 B

$774.56 B

$636.85 B

Total Debt

$181.01 B

$61.13 B

$708.05 B

$623.93 B

$678.3 B

Profit Margin

22.56%

7.87%

20.56%

16.33%

13.29%

5- Year Annual Expected Earnings Growth

8.5%

13.1%

6.84%

10.33%

7.85%

If QE3 is not much of a catalyst for the banks, then where is the reward? I think that earnings will be the catalyst to propel the banks and the XLF higher. The fact that the banks are undervalued gives the stocks a good starting point as many of them are trading below or near their book value per share. The average expected annual earnings growth for the entire XLF is 9.87% for the next five years. This is slightly below the market's expected annual growth of 10.1% over the same period. Given the undervaluation and the expected earnings growth, I think the performance of the XLF will approximately match the S&P 500's performance.

What QE3 will do for the banks is improve their balance sheets, which is their weak point. This will improve their financial situation while earnings grow.

Overall, I would expect the XLF and the banks to rise approximately in line with the S&P 500 over the next five years. This does not intrigue me as I would prefer to beat the performance of the market. However, this doesn't make the XLF a terrible investment. Investors should be able to retain their underlying investment while collecting a modest dividend. I don't think we'll fall over the fiscal cliff, so I believe the direction for the banks is higher, just not high enough for my taste. If we do fall off the fiscal cliff and enter a recession, I believe the banks will fall hard. So, the risk/reward is not that compelling.

Source: Weighing The Risk/Reward Relationship Of Banks And The XLF