Financials Are Up After Earnings – Will It Last?

Find out what to expect from financial stocks

By John Jagerson, Editor, SlingShot Trader

http://invstplc.com/ZHaqbn

I’ve said previously that the overuse of leverage and a narrow interest-rate spread will keep financial stocks underperforming in the near term. To be clear, I’m not downright bearish on the sector, but I don’t expect financials to be leading the pack — especially if the market itself turns lower.

ibm earnings stockThe last week’s earnings reports have provided several details that, I believe, support my point of view. The corporate market for debt is saturated and deal flow is starting to slow. It’s still early, but I think it’s safe to assume that bounce following earnings in the financial sector is a temporary ‘relief rally’ that isn’t likely to continue.

Let’s take a closer look at a specific example to understand why I remain convinced that the rally in financials is weak. Over the last year, I have been pointing at IBM (IBM) as one of the best examples of the excesses that will lead to this underperformance. More than 100% of the debt IBM has issued over the last few years was used to prop up its share-price and earnings per share through buybacks. However, it’s now time to pay the piper and IBM’s latest earnings report sent the stock to 2011’s lows.

At first glance, it may seem strange to point to IBM as evidence that the financial sector is likely to underperform but it makes sense if you think about the problems IBM (and many other firms) has created.

The Debt Market Is Reaching a Point of Saturation

A larger percentage of IBM’s profits are going to be spent on debt service than has been true in the past. This is bad for IBM’s dividend and a threatened downgrade if their debt to equity ratio worsened means they won’t be looking for new deals any time soon. Many of the best companies (size and credit-wise) are tapped out. There are fewer lucrative financing deals for the big investment banks.

The fact that the corporate market is getting closer to a saturation level for new debt and deals can be seen in the reaction to this quarter’s earnings reports. JPMorgan (JPM), Bank of America (BAC), Citigroup (C) and Goldman Sachs (GS) all dropped following their reports despite the generally positive performance over the last quarter. Even the bounce over the last few days can be attributed to another round of verbal intervention from the Federal Reserve and actual QE in Europe.

Investment Portfolios Are Getting More Volatile

IBM’s debt problems are also an issue for investment managers within the financial sector. Keep in mind that IBM isn’t unique, but it’s a good case-study for this issue. Investment portfolios are over-allocated to many of the most leveraged firms in the market. Warren Buffett’s holding company Berkshire Hathaway (BRK-A) owns 7% of IBM, which is equal to about 3.5% of the value of Berkshire’s class-A stock. IBM’s 13% share price decline this month has stunted Berkshire as well.

Berkshire’s class-B stock is almost 10% of the holdings of the SPDR Financial Sector ETF (XLF), which helps to make my primary argument. The financial sector doesn’t seem likely to enter a contraction, but it has very concentrated exposure to companies and sectors that aren’t growing as quickly as they have in the past. Because of the Fed’s recent intervention, there has been a short-term boost to small caps and finance, but it has basically been just enough to get prices back to resistance.

In the next chart you can see XLF has been pushed to second-quarter’s highs on declining volume. It’s not a guarantee of a decline, but technicians would argue that this is a very high-risk entry for new longs.

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SPDR Financial Sector ETF (XLF)

I think prudent managers should still have some exposure to the financial sector (except brokers), but it probably makes sense to make that allocation “underweight” compared to the rest of the portfolio. If you consider that my poster-child for bad debt management, IBM, has leverage ratios that are worse than Lehman Brothers’ before the financial crisis, I think you will agree that my concerns are reasonable.

To recap:  I suggest that the financial sector is likely to underperform the market in the near term regardless whether the major stock-indexes rise or fall into the end of 2014. A debt-saturated corporate market and over-leveraged investment managers should limit the possibility for earnings growth in the near term. If the Fed refuses to relaunch a new round of QE then the sector seems even more likely to remain flat. If I am right, is there a way to profit?

A group that is expected to lag the market isn’t the most productive area for short term speculation (in my opinion) however, there may still be opportunities here. It is still reasonable for investors to expect that the market could be due for a larger correction into the end of 2014.

Would put options on the big financial sector be a better hedge against a potential decline than puts on the S&P 500? I think that is a reasonable assumption and may be one of the best strategies for this sector. This was exactly what investors were doing in early September and, if it hadn’t been for oil’s collapse, their bets would have been almost perfect. It may be time to evaluate a second round of portfolio protection based on the weakness in the financial sector.

 John Jagerson and S. Wade Hansen are the editors of SlingShot Trader, helping investors capture options profits trading the news by using a proprietary 100% news-driven trading platform that turns event-driven pricing inefficiencies into fast profits. Get in on the next trade and get 1 free month today.

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Article printed from InvestorPlace Media, https://investorplace.com/2014/10/financials-are-up-after-earnings-will-it-last-ibm/.

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