Financial Stocks: Why the Rebound Has Stalled

Profits are doubling and tripling at many financial companies but their share prices are stuck in stock market limbo.

The reasons cited by portfolio managers and analysts can be summed up in two events on June 10: First, RealtyTrac released data showing U.S. home foreclosures hitting a record in May, up 44 percent from a year earlier. Second, in Washington, negotiators from the Senate and House of Representatives began meeting to write a final bill to reform the U.S. financial system.

Since the worst of the financial crisis in 2008 and 2009, "we've repaired a great deal of the damage" to financial businesses, says Michael Yoshikami, president and chief investment strategist at YCMNET Advisors.

According to Bloomberg, the earnings per share of the Standard & Poor's 500 financial sector are up 165.5 percent from a year earlier. Quarter-on-quarter, net income is up 244 percent: S&P 500 financial companies reported $34.4 billion in profits for the first quarter of 2010, up from net income of $10 billion in the final quarter of 2009.

Financial stocks are undergoing "a great earnings recovery," says BTIG Chief Market Strategist Mike O'Rourke. "Fundamentals now are improving and headed in the right direction."

Yet since financial companies began reporting these results—which, in the case of net income, beat the estimates of surveyed analysts by 49.5 percent—financial stocks have dropped like a rock. The S&P 500 financial sector index has lost 15.3 percent since a peak on Apr. 14, with financial companies now trading at the same level as last August.

Since Apr. 14, JPMorgan Chase (JPM) and Bank of America (BAC), the two largest banks by market capitalization in the S&P 500, are both down 20 percent. The broader S&P 500 is off 10.2 percent since Apr. 14.

Because of financial stocks' underperformance recently, analysts like Matthew Albrecht at Standard & Poor's see certain stocks in the sector at a price where "for long-term investors there are some opportunities in the group."

"Black Cloud" of Reform

Yet many investment managers say they are staying away from the financial sector for now. Though it's difficult to predict what form financial reform will eventually take, various proposals on the table would: limit banks' abilities to engage in trading; cut the amount of leverage, or debt, banks can use; and limit certain kinds of fees. All could hurt profits.

Financial reform is "a black cloud hanging over the sector," says Dan Genter, chief executive officer of RNC Genter. Until the regulations are set in place, "the rules are unknown," he says.

And investors find it difficult to predict the eventual decisions of the politicians writing the bill and the regulators who would implement it over the next several years, O'Rourke says. "We don't know how it's going to play out."

And, O'Rourke notes, the effects of reform on different players could vary greatly. Wells Fargo (WFC), for example, has much smaller Wall Street operations than JPMorgan, so it will be hurt less by changes in investment banking regulations.

Taking on more leverage at a bank can be risky, but it can also boost profits. If regulators sharply limit leverage, that could prevent banks from ever returning to the profit margins of previous years, says Jerry Webman, chief economist at OppenheimerFunds. "Earnings are probably [lower]," Webman says. However, "they may be much higher-quality and more stable earnings."

Rob Lutts, founder of Cabot Money Management, is an investment manager who is actually buying financial stocks. He expects financial reform to mostly focus on financial companies' Wall Street operations, with only a modest effect on Main Street financial businesses. "For the average bank, I don't think it will have a huge impact," he says.

Key Variables Difficult to Forecast

Even if the details of reform were settled—and the impact on financial bottom lines was clear—investors would remain puzzled over the current financial and economic environment. While profits are bouncing back, key variables for the financial sector, especially the economy and real estate markets, remain difficult to predict.

S&P's Albrecht notes that credit trends—borrowers' ability to pay back bank loans—have mostly stabilized. But he acknowledges the outlook is cloudy. "We're past the worst of it," he says, "but I don't think we're going to get better in a hurry."

Yoshikami worries that housing prices could begin falling again, which could cause problems for banks dealing with foreclosures and delinquent mortgages and loans on commercial real estate projects.

"Banks are still very worried," says William Rutherford, president of Rutherford Investment Management. "They're still reluctant to lend."

In other words, investors and bankers are both being prudent, waiting for events to unfold before they commit capital in an unpredictable environment.

    Before it's here, it's on the Bloomberg Terminal.