Pair off US banks this results season

Kathleen Brooks
IT WAS only 18 months ago that the large-cap US banking sector looked like it was on its knees. Since then the banks have been nursed back to health. Later this week we will find out how far they are on the road to recovery.

The two largest banks in the US, JP Morgan and Bank of America (BoA), which together hold deposits worth $1.4 trillion, are reporting earnings results for the first quarter on Wednesday and Friday. The current expectations for earnings according to Thomson Reuters are 65 cents per share for JP Morgan and 8 cents for BoA.

At the peak of the financial crisis JP Morgan was in the strongest shape of all US banks, while BoA was one of the hardest hit after it experienced vastlosses, including those caused by massive write-downs on toxic assets owned by Merrill Lynch, the investment bank it acquired very soon after Lehman Brothers went bust in 2008.

“This is the first time in a year that the entire large banking sector in the US should post positive earnings,” says John Velis, head of capital markets research at Russell Investments Group. This offers an opportunity for spread betters to make a short-term trade on the US banking sector.

For contrarian investors, a pairs trade, whereby you take a short position on JP Morgan and a long position on BoA, could perform well. JP Morgan entered the financial crisis with the strongest balance sheet. It avoided huge losses and instead was able to capitalise on the weakness of the banking sector and snap up its peers, such as Bear Stearns and Washington Mutual, at fire-sale prices.

Investors rewarded JP Morgan for its prudence and its share price has led the way during the recovery in the equity markets over the past year. After falling to a low of $20 per share in March 2009, JP Morgan stock has been on an upward trajectory, albeit with a few bumps in the road, and is currently trading at $38 per share.

But after rising nearly 50 per cent, the shares are beginning to look over-valued at more than 20 times earnings. A lot of good news has been priced into the stock price already, which might disappoint investors. One such disappointment could be caused by a delay in dividend payment. Analysts at Morningstar, an independent investment research firm, pushed back its expectation of a dividend from the bank to the second half of this year after JP Morgan announced results for the fourth quarter.

Originally it expected a dividend to be distributed to investors in the first half. Morningstar said it was happy to wait a few more quarters for a dividend, allowing the bank to bolster its capital base, but investors might not be as patient. If there is no announcement of an upcoming dividend in next week’s results then it could tempt nervous investors to sell the stock.

In contrast, BoA, one of the largest recipients of bailout funds from the US Treasury, could surprise investors in the coming weeks. The outlook for the bank has improved dramatically in recent months. New BoA chief executive Brian Moynihan said that losses generated from bad loans had peaked in the fourth quarter of last year. On top of good future prospects for profits from the bank, its stock looks less expensive than JP Morgan’s.

Equity analysts at Morningstar also note that BoA’s underlying businesses – banking advisory, underwriting, asset management and deposit taking – escaped the worst of the credit crunch. They remain fairly strong and can help the bank to recover. Together these businesses “give BoA the foundation it will need to succeed in the long-run,” analysts wrote in a note released earlier this year.

A long BoA and short JP Morgan trade is good for spread betters with a short- to medium-term investment horizon because the longer-term outlook for the banking sector remains uncertain. Although Russell Investment Group’s Velis says that overall US banks should release good results for the first quarter, it is questionable if these banks will ever be able to return to the strong profits they generated prior to the financial crisis.

“The whole business model for the banks is changing, people are borrowing less, which makes the longer term outlook for the banks less favourable,” says Velis. “The banks won’t make the huge profits they did earlier in the decade, and right now we don’t know where the banks profits will come from.” Regulation is another hurdle for the banks. A global banking tax is in the pipeline along with changes to domestic regulation. In the long-term, the banks should be avoided. But in the short-term, there are profits to be taken.