Financials Look Fragile for Q3

Despite rising earnings, the eurozone crisis will continue to weigh

By Dan Burrows, InvestorPlace Feature Writer

It’s promising to be an interesting quarter for investors in financial stocks — and not just because they can expect an update on JPMorgan Chase‘s (NYSE:JPM) $2 billion-and-counting trading loss.

Financials are forecast to notch the highest growth rate of any sector of the S&P 500 Index, thanks largely to easy comparisons, and yet don’t be surprised if financial stocks continue to languish.

That’s because the outlook for financial shares is intimately tied to the debt crisis in the eurozone, and it’s hard to see that going away anytime soon.

Besides, it’s not as though the killers of minuscule interest-rate spreads and a dearth of trading, IPOs and M&A activity have let up since the first quarter.

If anything, investors should gird themselves for Wall Street cutting its outlooks ahead of reporting season, which kicks off in just a couple of weeks, writes Keefe, Bruyette & Woods bank analyst Frederick Cannon.

“We expect the estimate revisions to follow the pattern of the past few weeks, with largely downward revisions for most financials, especially banks and brokers, due to the flattening of the yield curve and weak trading revenues,” Cannon says in a recent note to clients.

Surprisingly, financial stocks are expected to be the key driver of S&P 500 second-quarter earnings growth — but not necessarily in a way that will help share prices. Indeed, financial stocks are forecast to post year-over-year earnings growth of 54%, according to FactSet.

That sounds great until you learn that the sector is benefiting from an easy comparison to last year’s quarter, largely because of Bank of America‘s (NYSE:BAC) $8.5 billion mortgage lawsuit settlement.

Heck, that whopping year-ago hit to BofA’s earnings isn’t just going to make the bank’s bottom line look a whole lot better, not to mention that of the entire financial sector — it’s actually expected to prop up the entire market.

The second-quarter earnings growth rate for the S&P 500 is currently estimated at 6.3%, according to data from Thomson Reuters. But exclude BofA from the results and it slides to just 1.1%.

FactSet data is even gloomier, putting the current-quarter S&P 500 growth rate at 3.3%. Without BofA’s contribution, that falls to -1.4%.

To get a sense of how much BofA’s year-ago loss is distorting the upcoming reporting season’s bottom line, remember that despite a projected profit jump of over 54%, financial-sector revenue is seen inching up only 3.6%. Or, take BofA out of the sector’s results, and financials are forecast to grow earnings at an 8.9% rate.

Although BofA is the biggest contributor, plenty of other firms are also helping the sector with easy year-over-year comparisons, FactSet notes. Morgan Stanley (NYSE:MS), Allstate (NYSE:ALL) and Travelers (NYSE:TRV) all reported losses in the year-ago quarter and are now predicted to be large contributors to earnings growth in the upcoming reporting season.

True, easy comparisons and low expectations are usually good for stocks, but with the crisis in the eurozone calling the shots, any earnings-induced pops will probably have a short half-life.

Intense uncertainty and anxiety over the fates of Greece and especially Spain have caused financials to lose 9.2% so far in the current quarter, making them the second-worst-performing sector of the S&P 500. (Only the energy sector has performed worse.) It’s probably fair to expect more of the same.

“The crumbling economies of peripheral European nations have held global markets hostage for well over a month now — reminiscent of conditions that were prevalent toward the latter half of 2011,” Trefis analysts write.

Shares in RBS (NYSE: RBS), Morgan Stanley and Citigroup (NYSE:C) have been pressured in part because of their trading exposure to debt issued by the affected countries, Trefis notes. But the euroquake doesn’t much discriminate in the pain it inflicts on financial stocks.

The eurozone is determining the fate of financial stocks, and an earnings season distorted by year-ago losses is unlikely to help share prices much past a short-term lift. If the past three months are any guide, the third quarter looks to be volatile and possibly even dangerous for financial stocks.

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