How to play the financial sector ahead of earnings

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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 ( C ), M&T Bank ( MTB ), U.S. Bancorp ( USB ), and BB&T Corp. ( BBT ).

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 ( WFC ), 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 whole.

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 financials.

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.


Chart courtesy of www.stockcharts.com .

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 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: BBT , C , MTB , USB , WFC

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