Why Banks Should Be on Your Radar

Includes: BAC, IPF, JPM, XLF
by: Efficient Alpha
JP Morgan (JPM) surprised Wednesday with net income 13 percent above average analyst estimates. Second quarter net income increased to $5.43 billion from $4.8 billion a year ago, with earnings per share gaining 16.5 percent on last year’s report. Though $1.2 billion was from a non-recurring reduction in credit-card loss due to better performing credit trends, the profit from investment banking jumped 49 percent. JP Morgan stock was up as high as four percent on Thursday before settling at $40.35, a gain of 1.8% percent over Wednesday’s closing price.
The Financial Select SPDR (XLF) closed down 0.7 percent Thursday to end at $14.88. The ETF has under-performed the S&P500 for just about every time period imaginable, lagging the broader index by 24.3 percent over the last year. Throw in a still abysmally weak US housing market and the snowballing debt crisis in Europe, and most investors would sleep better with an underweight allocation in their portfolio.
So why should the informed investor consider a larger weighting in banks? A number of fundamental factors are turning positive for the sector. As the JP Morgan report shows, 30-day delinquencies have been falling steadily from almost 5 percent in 2010 to under 3 percent reported for the second quarter. A more fiscally responsible consumer class bodes well for future lending and lower credit loss reserves. A report released by RealtyTrac shows foreclosure filings sank 29% compared with the same period last year. The CEO of RealyTrac, James Saccacio, attributes the drop to processing delays due to legal action and notes that the estimated one million additional foreclosures may be pushed out to 2012 or later.
The report has generally been taken negatively for the housing market, but there may be a silver lining for the markets and banks. The 800-pound gorilla in the housing market has been the overhang of foreclosures and shadow inventory depressing the prices on new and existing homes. The percentage of foreclosed home sales to total sales has been on the order of 30% for most of the country since the housing crisis erupted. With this report, we have the possibility of a slower supply of foreclosures coming to market. This could allow the economy time to pick up and draw down on some of the oversupply. At minimum, the reduced number of foreclosures on the market will help to put support on the median home price.
Risks still remain for any investment in the banking sector. Italy approved further austerity measures and executed a successful bond sale on Thursday, but this by no means will be the end of the debt crisis in Europe. Fortunately, credit problems across the Atlantic mean less for US banks than their European counterparts. A default, or additional downgrades, would certainly affect the US banking sector but the risk can be hedged with a short on the Euro or the SPDR S&P International Finance (IPF) ETF, which carries half its holdings in European banks versus a 97% weighting in US banks held in XLF.
Bank of America’s (BAC) nearly $9 billion settlement of its mortgage-backed securities problem will not be the end of the mess in which banks find themselves. Most of the individual banks have yet to come to an agreement with the states’ attorneys general over modified mortgage litigation. However, these problems, and the per share effects, have largely been priced into stocks at this point. In April, the Federal Reserve settled with the largest 14 mortgage servicers in what amounted to little more than an order to comply with procedural and supervisory regulations.
Estimates for revenue growth in financials are lowest of the 10 sectors -- at about half a percent, according to Factset -- but the smart investor does not invest on current earnings. Positive fundamentals and hedgeable risks will allow an investment in financials to outperform in coming quarters.
Disclosure: I am long XLF.