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EARNING UPDATE $JMP JMP Group LLC for quarter ending q_Jun18 – Revenue rose but Margins contracted

[s2If !current_user_can(access_s2member_level0)]Please login to read the earning update on JMP [lwa][/s2If][s2If current_user_can(access_s2member_level0)]JMP Group LLC reported earnings (EPS) of -0.09 per share for the quarter ending q_Jun18. This is vis-vis -0.01 per share for the previous quarter ending q_Mar18, a decline of 800 %. Compared to last year same quarter (q_Jun17), earnings grew…

Financial stocks stumbled hard out of the gates in 2016. Some of the biggest players in the U.S. like JP Morgan (JPM), Wells Fargo (WFC) and Bank of America (BAC) got completely clobbered in the first six weeks. From January 4 to February 11, when broad domestic markets shuddered, JP Morgan declined -19.62%, Wells Fargo came in at -16.92% and Bank of America cratered over -33%. Shares recovered a bit by the end of the quarter, but each name was still down over 10% on March 31 – while the S&P 500 was back in positive territory.

So what happened?

We could point to any number of factors that may have exaggerated the downside for banks: negative interest rate policy in Europe (and the mere thought of it in the U.S.), worries over Energy loan exposure, capital ratio questions in Europe and the list goes on. Negative interest rates and a flattening yield curve spell headwinds for bank margins, yes. But, the extent of selling pressures seemed to outweigh the fundamental impact to banks earnings outlooks, particularly in the U.S. The reality is that we’re not dealing with negative interest rates here, and banks are better capitalized than they’ve been in decades. So, the selling may have gone too far.

Individual names like JP Morgan and Bank of America were dealt a blow and may seem like attractive options for bargain hunters. But, even if you look at the sector in aggregate, there is still a case for attractive valuations relative to the S&P 500:  

Q1 2016 Performance

S&P 500 (price only): +0.77%

iShares U.S. Financials (IYF): -5.34%

iShares U.S. Regional Banks (IAT): -9.08%

Is the Outlook for Banks Good Enough to Warrant Increased Exposure?

The fundamentals for U.S. banks are generally doing fine. The ‘bad energy loan’ story is the easiest to dismiss – energy loans only account for about 3% of total U.S. bank loans and most banks have cushioned balance sheets in the event some of them default. Most energy loans are made in the debt markets, think MLPs and high yield bonds.

The negative interest rate concern does not really impact U.S. banks, at least in my view. The Fed still pays 0.5% on reserves (current fed funds rate) and our view is that the fed funds rate will rise over the course of the year, perhaps to 1% or higher. Banks in the U.S. and Europe are both very well-capitalized with Tier 1 ratios (core equity capital relative to total risk-weighted assets) and well over double what they were in 2008. They’re prepared for a crisis that, more than likely, isn’t coming this year.

Loan growth is also good. Consumer loans and industrial loans have both been growing at a modestly positive clip over the last few years. We do not expect a material change to that as long as the yield curve remains upward sloping (which we think it will in 2016).

Source: Federal Reserve Bank of St. Louis

Bank failures are also very few and far between these days which can provide a sentiment boost for the health of the sector. Last year, there were only eight.

Source: Federal Deposit Insurance Corporation

Earnings paint a bit of a different picture, however. Estimates for the Finance sector have dropped -9.8% since the start of the year, with Q1 earnings growth for the sector now expected to decline -10% from the same period last year. J.P. Morgan (JPM), Bank of America (BAC), and Citigroup (C) all suffered material negative revisions due to a slightly flatter yield curve (the 10-year Treasury yield dropped by 50 basis points in the quarter), weak capital markets and a muted investment banking environment due to heightened volatility and uncertainty. It’s possible that Q1 total earnings could be down -10.9% from the same period last year, on -2.2% lower revenues. This will be the 4th quarter in a row of negative earnings growth for the index.

There are also regulatory uncertainties that have held banks back. Dodd-Frank rules are still not fully understood or established and some campaign trail rhetoric is targeting big banks, which creates uncertainties in how the sector approaches risk-taking. Less risk taking means lower profit potential, which can in turn inhibit compelling multiple growth.  

Bottom Line for Investors

The volatility experienced early this year was, perhaps, overly sentiment driven considering that there has not been a meaningful breakdown in fundamentals. At face value, big U.S. banks are trading at more attractive valuations than they were to start the year. Risks to profits remain, however, so the case for financials must have a basis in a very long-term view, in my opinion. If you were considering a longer-term asset allocation shift to increase portfolio weight to financials, you’d have cheaper entry points now. It may be worth a close look for the long-term investor.

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For Part 2, see S&P 500 Sector ETFs: A Look Under the Hood, Part 2

Financial Select Sector SPDR

The worst-performing sector ETF of the past 10 years and since the 1998 inception of the Select Sector SPDRs is, of course, the Financial Select Sector SPDR (XLF). Over the past 10 years, it returned 0.14% per year. Since inception, it managed to eke out 2.6% per year. 

Given that the worst financial crisis since 1907 centered around this sector, it’s remarkable that its returns are positive at all! 

Interestingly — and indicative of how fall the global banking giants have fallen — the largest holding in this ETF isn’t a bank at all. It’s Warren Buffett’s conglomerate Berkshire Hathaway (BRK.B), which is considered an insurance company by Standard & Poor’s. Berkshire Hathaway makes up just shy of 9% of the portfolio. 

Following quickly behind is one of Berkshire Hathaway’s largest long-term holdings, Wells Fargo (WFC). And of course, following Wells Fargo are some of its less prudent competitors, JP Morgan Chase (JPM), Bank of America (BAC) and Citigroup (C). Most of the rest of the portfolio is made up of smaller banks, asset managers and brokerage houses. 

For the time being, XLF also has a decent-sized exposure to REITs, at about 12% of the portfolio. This is absurd, as there is no practical reason why a shopping mall landlord like Simon Property Group (SPG) should ever be in the same sector ETF as Goldman Sachs (GS). 

Luckily, this anomaly won’t be around for much longer. Standard & Poor’s is giving REITs their own standalone sector, and presumably the State Street Select Sector SPDR ETFs will follow suit. (The SPDR ETFs do deviate from time to time. For example, telecom and technology, which S&P breaks into two sectors, share a single SPDR ETF.)

Health Care Select Sector SPDR

Next up is the Health Care Select Sector SPDR (XLV). The Health Care ETF has been one of the very best performers, generating annualized 28.1% returns over the past three years and 8.5% annualized returns since the inception of the SPDR series in 1998. 28.1% annualized returns are the stuff of 1990s dot-com memory, yet came from one of the S&P 500’s more conservative sectors. 

Call it the Obamacare trade. 

What you get with XLV is a who’s who list of big pharmaceutical companies like Johnson & Johnson (JNJ), Pfizer (PFE) and Merck (MRK). You also get exposure to the bigger and more established biotech names, like Gilead Sciences (GILD) and Amgen (AMGN), and to health insurance companies. 

What you are distinctly not getting is a good dividend payer. The days when the health sector was considered a high-yield sector are over. XLV is one of the lowest-yielding sector funds with a dividend yield of just 1.3%.

Industrials Select Sector SPDR

Next we get to the Industrials Select Sector SPDR (XLI). Despite being considered a cyclical sector, the industrials have managed to put up consistent and respectable returns over the life of the SPDR series. Over the past three-, five- and 10-year periods, XLI generated returns of 18%, 17.1% and 7.8%, respectively. 

The holdings here are going to include household names like General Electric — a company that is thankfully getting back to its industrial roots and leaving its experimentation as a bank in the past. 

3M Co (MMM), Boeing (BA) and Lockheed Martin (LMT) also make the top 10, as you might expect. But XLI also has quite a few stocks that you might not think of as “industrials,” per se, including airlines like Delta Air Lines (DAL) and parcel companies like United Parcel Service (UPS). 

And somewhat bizarrely, white-collar headhunting firm Robert Half International (RHI) makes the list as well. Don’t expect much in the way of dividends with this ETF. At 1.8%, its yield is about in line with the broader S&P 500.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.