Why Financial SPDR ETF Is a Buy – Bank Earnings Better Than You Think

Although mega banks JPMorgan (JPM), Citigroup (C), and Bank of America (BAC) have all reported better than expected earnings results — only to be knocked to the ground by unimpressed investors. The problem, is that the earnings beats are being driven by reduction in loan loss provisions, which are like accounting piggybanks that are used to protect against defaults.

An optimist would say that these reductions are a result of a strengthening economy and improvements in the number of people who can pay their loans on time. You can see this in the way that loan charge-offs are declining: Quarter-over-quarter, they fell $1.2 billion at Bank of America, $422 million at Citigroup, and $2.2 billion at JPMorgan.

And the trends are expected to continue as job creation ramps up. On Thursday, initial weekly jobless claims fell to 429k from 454k previously — falling out of a range between roughly 450k and 500k that the metric has been stuck in since October.

But the skeptics are having none of it. Bank stocks have tumbled over the last two days on concerns bank executives are using creative tactics to dress up their earnings — prematurely tapping into their credit reserves. There are also concerns over a decline in revenues: The top line dropped 7.6% year-over-year at JPMorgan, 33.3% at Citigroup, and 11% at Bank of America. And of course, there are worries over the hit to profitability related to the passage of financial regulatory reform legislation in Washington.

As a result, you can see in the chart above how bank stocks have failed at triple top resistance that has contained the Financial SPDR (XLF) since May. And this underperformance by the financials is what’s dragging down the broad market. 

Are the concerns valid? Or is this another example of excessive pessimism?

I think there is some reason for optimism. The decline in loan losses is an unmitigated positive. And the decline in revenue might be due to some shrewd prepositioning by executives to protect themselves against an increase in interest rates. Analysts at FBR Capital note that JPMorgan shortened the average maturity of its securities portfolio. Translation: The bank is selling long-term Treasury bonds and buying more short-term Treasury bills instead.

That cuts the losses the bank will take on its portfolio should the economy continue to improve and the Fed starts raising rates. This is exactly the right step to take and will help boost profitability into the future. This is because the value of long-term bonds drop more severely than short-term bonds as rates rise.

And as for the hit from regulatory reform, I think it’s already priced in. A recent Citigroup analysis of the legislation found that under very conservative assumptions, Bank of America would see earnings per share fall 16% while JPMorgan would suffer an 18% impact. From the April high, Bank of America has dropped 28% while JPMorgan is down nearly 19%.

Once the XLF moves through $15, I’m a buyer.

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Article printed from InvestorPlace Media, https://investorplace.com/2010/07/bank-earnings-financial-etf-xlf/.

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