Can Banks’ Big Rally Keep Running?

JPMorgan Chase (NYSE:JPM) and Wells Fargo (NYSE:WFC) kick off bank earnings season Friday, and there’s sure to be a lot of noise. The ugly headlines, after all, just keep coming.

From JPMorgan’s London Whale trading loss and a new lawsuit from the New York State Attorney General to the latest federal lawsuit against Wells Fargo over mortgage securities, you’d think investors would have had it with litigation and headline risk.

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But you’d be wrong. Despite a weak economy, legal settlements, trading debacles and fresh lawsuits, it’s been a great year to be an investor in bank stocks.

Whether that outperformance can last is the big fourth-quarter question.

Don’t look now, but financials have been far and away the best-performing sector of the S&P 500 for both the quarter and year-to-date, posting gains of 2.1% and 22.4%, respectively. By comparison, the broader market gained 16.6% for the year-to-date as of Oct. 9, meaning financials have outperformed by a whopping 5.8 percentage points.

The gains have been widespread and easy to participate in, whether it be through funds or stock picking. Just have a look at the tape:

The popular financial sector exchange-traded fund, the Financial Select Sector SPDR (NYSE:XLF), has gained more than 22% in 2012.

JPMorgan and Bank of America (NYSE:BAC), the nation’s largest banks by assets, are up 25% and 64%, respectively, so far this year.

Over at Citigroup (NYSE:C), the original too-big-to-fail financial supermarket, shares are up 32% on the year. Wells Fargo, the nation’s biggest mortgage lender, has gained about 27%.

Regional banks are booming, too. The SPDR KBW Regional Banking ETF (NYSE:KRE) is up a market-beating 18%. U.S. Bancorp (NYSE:USB), for example, has added more than 27% for the year.

Investment banking? Check. Goldman Sachs (NYSE:GS) is up 32% in 2012, while even beleaguered Morgan Stanley‘s (NYSE:MS) 14% rise has allowed it to keep pace with the broader market.

Much of the enthusiasm for bank stocks can be explained by anticipation of and then delivery of a third round of quantitative easing from the Federal Reserve, as well as easing from its European counterpart.

But at the same time, on a more fundamental level, banks are on the mend and poised to post much higher profits over the year-ago period. Analysts at Keefe, Bruyette & Woods expect the banks’ third-quarter earnings to look a lot like they did in the second quarter, which wouldn’t be too bad at all.

As we saw when second-quarter results came out, the banking business and its balance sheets are indeed healing. More borrowers are paying their loans on time, meaning banks are setting aside less money for loan losses, with attendant benefits to the bottom line. And although a dearth of deal activity and turbulent markets are still weighing on investment banking, a healthier housing market is boosting mortgages and refinancing activity.

“Core revenues should look a lot like last quarter with debt underwriting and mortgage banking showing the most strength,” KBW analysts write in a recent report to clients. “While activity remains sluggish, improving capital and continued market share gains should help improve valuations for the group.”

Be forewarned that the macro environment is likely to remain choppy, and if traders suddenly flee the risk-on trade, financials, after their big rally, will no doubt become a source of funds. But the underlying fundamentals should continue to improve, KBW says.

And that leaves us cautiously optimistic that banks, from the regionals to the money centers, can maintain market leadership though year-end.

As of this writing, Dan Burrows held no positions in any securities mentioned here.

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