July 21, 2014 - Banking on the Financial Sector
The financial sector's meltdown played a huge role in the recession, but in the years since the financial crisis, most of the big banks have gotten back on the right track, with some now trading near record highs.
Two of the largest banks in the world are Wells Fargo (WFC) and JP Morgan Chase (JPM). Both stocks have bounced back strongly from the recession, and have recently hit all-time highs.
Both have already reported their quarterly results, so let's look at the numbers and see what we can learn from their reports.
Wells Fargo kicked off the earnings season for the financial sector with its quarterly report, and the take-away from its report was that the financial sector continues to move in the right direction. What really impressed Wall Street was the company's mortgage originations, which were up 31% from the first quarter, a clear sign that rising interest rates were not having as big an impact as some feared.
During the same period last year, just 44% of mortgage originations were from new home purchases, but that percentage jumped to 74% in the most recent quarter.
Wells Fargo stock charged higher following its earnings report.
Following in Wells Fargo's footsteps, JP Morgan reported its second quarter results a few days later, topping analyst estimates on both the top and bottom lines. Mortgage lending and trading activity were expected to weigh heavily on the bank during the quarter, but the impact was less than expected, which translated into a better-than-expected quarter.
Like Wells Fargo, JP Morgan stock edged higher on the news.
Citigroup (C) and Goldman Sachs (GS) have also already posted quarterly results, and they too have been able to outpace analyst estimates.
Based on the earnings reports from four of the biggest banks in the world, things appear to be moving in the right direction for the sector.
While things look good for the moment, there are always risks on the horizon for the financial industry. With the Federal Reserve cutting back on its bond-buying program, interest rates are likely to continue inching higher, which will undoubtedly have some impact on mortgage applications moving forward. The housing market continues to show signs of strength, but it would be foolish to assume that the market is immune to a slowdown resulting from higher rates.
The industry is also vulnerable to falling trading volumes, and any slowdowns in this area can derail the sector as well. During JP Morgan's quarter, fixed-income trading revenue was down 15%. While the results were not as bad as some had feared, they are still a warning sign that things could quickly turn and send the stock lower.
The take-away from the reports we have seen this quarter is that the sector remains in good health, but there are still plenty of reasons to be cautious moving forward. Consequently, I would like to take a bullish position on the sector, but will look to diversify any investment, and hedge my trade with a decent amount of downside protection in case weakness does begin to enter the sector.
Both of these goals can be accomplished with a trade on the exchange-traded-fund Financial Select Sector SPDR ETF (XLF), which holds some of the biggest names in the financial sector.
Chart courtesy of stockcharts.com
The ETF is set up to track the performance of the Financial Select Sector Index. Among its top ten holdings are industry heavyweights Wells Fargo, Berkshire Hathaway (BRK.B), JP Morgan (JPM), Bank of America (BAC), and Citigroup.
Strength in the financial sector has resulted in strong performance of the XLF over the last year, and the ETF is currently trading just 1.8% below its 52-week high.
A nice hedged trade on XLF would be the December 16/21 bull-put credit spread. To set up this trade, you would sell the December 21 put while buying the same number of December 16 puts for a credit of 30 cents. The trade has a target return of 6.4%, which is 15.0% on an annualized basis (for comparison purposes only). XLF is currently trading at $22.65, giving our trade 6.0% downside protection.