Bank on sector-wide financial strength

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Michael Fowlkes 01/20/2014

Last week was all about the big financials. The industry took center stage, with nearly all the big players reporting results for their most recent quarters.

Overall, it was a pretty upbeat week for the sector. There were a couple earnings misses here and there, but overall the theme of the week was positive, and that the financial industry remains in good health.

JP Morgan ( JPM ) got the ball rolling on Tuesday morning. The bank reported a 7.3% drop in earnings, mostly a result of legal costs. Taking out the legal expenses, the company earned $1.40 a share, on revenues of $24.1 billion. Wall Street expected earnings of $1.35 on revenues of $23.67 billion. In the days following the report, the stock has traded slightly higher.

Wells Fargo ( WFC ) was another closely-watched bank that reported on the same day as JP Morgan. It also had upbeat numbers, topping analyst estimates for both earnings and revenues. The company had earnings of $1.00 per share, which topped estimates by two pennies. It had year over year earnings growth of 10%, but its revenues, while topping estimates, were down 5% from the same period last year.

Then, we have some ugly reports, most notably Citigroup ( C ). That company reported its earnings on January 16, and the stock took a big hit following the report. Analysts expected earnings of 95 cents per share, but actual earnings were much lower at just 82 cents. Revenues during the quarter were $17.8 billion, down 1% from the previous year. The silver lining to the disappointment was that income was up 21% year over year, just lower than expected.

Goldman Sachs ( GS ) also disappointed, while Bank of America ( BAC ) and SunTrust (STI) both put up strong numbers.

While not everything has been great with the earnings from the sector, overall it has been a positive week, which should help keep upside momentum in bank stocks moving forward. However, there are enough warning signs to take a guarded approach to playing the sector.

One recurring theme this earnings season has been a drop in mortgage lending. This is a result of rising interest rates, and it is reasonable to assume that the trend will continue as rates inch higher through 2014 now that the Federal Reserve has begun tapering its monetary easing program.

The lower mortgage lending is a reason for concern, but what this earnings season tells me is that the drop is being offset by improved credit quality, which I expect to continue.

Overall, I am bullish on the sector, but realize that enough risk exists to make sure than any new investments in the sector are highly diversified, and with some acceptable level of downside protection in case rising rates start to have a greater impact on earnings.

A good diversified play on the sector is the exchange-traded fund iShares US Financials (IYF). IYF tracks the results of the Dow Jones U.S. Financials Index, so you can diversify over all the major financial institutions. Among its top holdings are JP Morgan, Wells Fargo, Berkshire Hathaway (BRK.B) Bank of America, and Citigroup.


Chart courtesy of Stockcharts.com

With IYF holding so many of the major financial stocks, you are able to play the sector, but protect yourself against any downside in the event that a couple of the major banks run into some trouble. Setting up a hedged trade on IYF can provide additional protection, allowing us to still pull in a nice return even if the entire sector turns negative.

A nice hedged trade on IYF would be the May 70/75 bull put credit spread. In this trade, you would sell the May 75 put while buying the same number of May 70 puts for a credit of 25 cents. This trade has a target return of 5.3%, which is 16.0% on an annualized basis (for comparison purposes only). IYF is currently trading at $80.69, so this trade has 6.7% downside protection.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

Originally published on InvestorsObserver.com


This article appears in: Investing , Options

Referenced Stocks: BAC , C , GS , JPM , WFC

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