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The earnings season for the third quarter of the current year has arrived. The financials that will outperform their peers in the U.S. financial sector will rely heavily on improving housing markets, improvement in the quality of credit, and will focus on cost reduction. Headwinds from the prolonged, record low interest rate environment will create a downward pressure on the net interest margin that these financials will be able to earn. JPMorgan (NYSE:JPM) and Wells Fargo (NYSE:WFC) are both expected to post their respective performances for the third quarter of the current year on October 12, 2012. Both these banks broke profit records in the year 2011, and are expected to do so yet again. Therefore, we recommend our investors to long Wells Fargo. We, however, still believe that JPMorgan needs to ensure the development and implementation of effective internal controls. Until that happens, we recommend our investors to stay away from the bank.

Wells Fargo

In an earlier report we saw why Wells Fargo was one of the most favored American banks. The bank is strongly positioned to benefit from the improving housing markets, which have already bottomed. Its robust capital base and simple business model make the stock the second-biggest holding in Warren Buffett's fund.

Plenty of encouraging data suggests that the U.S. housing market has begun its ride upwards. The Case Shiller Price index (Composite 20), a prime indicator of U.S. home prices, is currently at 142.1, up from 140.5 a year ago and 141.1 last month. Mortgage Originations in the U.S. have reached the current level of $372 billion, up from $363 billion in the last quarter. In the previous quarter, a third of the total originations were made by WFC. Therefore, we believe that WFC will be the single largest beneficiary of the improvement in the U.S. housing market as it is the largest mortgage lender among other money-center banks. During the second quarter of the current year, despite a fall in revenues, profits boosted 17%, largely due to mortgage-income.

The bank has a history of surprising analysts when it comes to both revenues and earnings that the bank posts on a quarterly basis. The bank has posted a 60 basis point average revenue surprise over the past five quarters, while the average earnings surprise is 46 basis points.

The bank's cost cutting program, under the name of Project Compass, has been a success in the second quarter of the current year. The bank aims to reduce expenses worth $1.5 billion by the end of the current year. The successful implementation of the project in the third and fourth quarters of the current year will determine the improvement in the coming quarters' results.

The bank is followed by 32 analysts, who have a consensus mean earnings per share estimate of $0.87. The earnings per share estimate for the third quarter of the current year has moved upwards from $0.84 per share 90 days ago, to the current $0.87. This reflects the optimism and confidence that the Street has in the performance of the bank. A total of 22 analysts have a consensus mean revenue estimate of $21.45 billion.

JPMorgan

JPMorgan, the biggest U.S. bank with regards to assets, is currently faced with issues regarding its internal control systems. Weaknesses in its internal control systems have led to a huge trading loss, which has now swelled to around $5.8 billion. Initially, the bank disclosed a loss of $2 billion. Most recently, the bank was sued by Eric Schneiderman, the New York Attorney General, for packaging and selling fraudulent mortgage-backed securities during the U.S. housing bubble.

JPMorgan, like Wells Fargo, has a history of producing positive surprises when it comes to quarterly earnings and revenues. The bank produced a significant average EPS surprise of 15% over each of the past five quarters. Revenues largely remained in line with consensus mean estimates. In the most recent quarter, the bank surprised the Street by exceeding its revenue estimate by 4.6%, while the earnings per share figure turned out to be 5% below expectations. Much of the disappointment in the earnings per share figure was associated with the trading loss. The bank's treasury and securities, retail services, and investment banking were better than the last quarter, which resulted in revenues being better than expected.

The 29 analysts covering the bank are expecting earnings per share of $1.22 on revenues of $24.55 billion for the third quarter of the year. The mean consensus earnings estimates for the third quarter of the current year have been revised upwards from $1.05, 90 days ago.

Valuations:

Wells Fargo trades at a premium of 39% to its book value, as compared to JPM which trades at a discount of 14%.

Source: 1 U.S. Large Cap Bank To Buy This Week On Earnings, 1 To Avoid