How to play the financial sector ahead of earnings
Michael Fowlkes 10/14/2013
It's that time of year again… earnings season. Four times a
year Wall Street gets a look inside publicly traded companies for
a better understanding of how good or bad business is going.
This week, the big financials will take center stage, with
several big name banks lined up to report their quarterly
figures. Among the names preparing to report include Citigroup (
), M&T Bank (
), U.S. Bancorp (
), and BB&T Corp. (
The recent recession hit the financial sector hard, but in the
years since, the industry has come roaring back and is running on
all cylinders. The first of the major financials to report its
earnings this season was Wells Fargo (
), which reported a new record for its profit… which was the
tenth consecutive quarter doing such.
While the company reported record profit numbers, the overall
picture was not so pretty. Revenues were down, with the bank's
mortgage business starting to stall. The bank got $87 billion
worth of mortgage applications during the quarter, which was a
steep decline from the $188 billion it received during the same
period last year.
The financial industry has been bolstered by a strong housing
market, which has benefited from a near-zero-interest rate policy
by the Federal Reserve. The problem is that while the Federal
Reserve has yet to begin tapering its monetary easing, interest
rates have already started to rise. Once the Fed does begin to
taper interest rates will move even higher, and put serious
pressure on the housing recovery, which in turn will impact the
mortgage business of big banks.
Investors have been enjoying strong gains in the financial
sector this year, but for the good times to continue through the
end of the year, it needs to be a great earnings season for the
industry. Even with its record profits, Wells Fargo stock fell
more than 2%... a clear sign that investors are worried about the
impact higher interest rates is having on the sector as a
JP Morgan (JPM) has also already reported. Excluding
non-recurring items, the company posted a profit of $1.42 per
share, topping the $1.28 analysts were expecting, and its
revenues of $23.9 billion were in-line with analysts estimates.
The stock traded up 1% following its earnings report.
To get a better idea of just how strong the financial sector
has been this year, we just need to look at the exchange-traded
fund Financial Select Sector SPDR (XLF). The index is set up to
track The Financial Sector Index, and since the start of the
year, XLF has traded up 24.6%.
XLF's top holdings include Wells Fargo, JP Morgan, Bank of
America (BAC), Citigroup, and American International Group (AIG).
With the ETF containing all the big names of the sector, it will
react to the upcoming earnings report from the big
With Wells Fargo and JP Morgan both posting better than
expected earnings, I am bullish on the upcoming reports from the
other financials, but there is a real danger that slowing
mortgage applications could result in a disappointment or two
along the way. Because of the potential for some earnings misses,
a great way to play the financial sector ahead of the upcoming
earnings reports is with a trade on XLF. Playing XLF allows you
to take advantage of a good earnings season, but diversifies your
position over enough financials in order to weather an earnings
miss or two.
In order to further protect the investment, I would suggest
setting up a hedged trade on XLF just for protection in case of a
string of bad reports.
A nice hedged trade on XLF would be the January 13/18 bull put
credit spread. In this trade, you would sell the January 18 put
while buying the same number of January 13 puts for a credit of
20 cents. This trade has a target return of 4.2%, which is 15.4%
on an annualized basis (for comparison purposes only). With XLF
currently trading at $20.18, this trade has 9.8% downside