Why Financial Sector Earnings Are a Deceptive Farce

Because of a slew of earnings reports, this has been called “the week of truth” for the financial sector. However, a deeper look at the sector shows that big bank earnings reports are at best symbolic. One could even say that the whole ritual is utterly deceptive.

Earnings season is in full swing and most financial heavy weights are due to report this week.

Yahoo!Finance writes that: “It’s a make or break week for the financial sector with five of six of the nation’s largest banks (JPMorgan, Goldman Sachs, Citigroup, Bank of America, and Morgan Stanley) scheduled to report fourth-quarter earnings results” this week.

Earnings are directly related to stock market valuations, but big bank earnings releases are nothing more than a ritualistic farce. Why?

There’s no simple answer, but the next few minutes will be well worth your time. Warning! Knowledge about banks’ (corresponding ETF: SPDR S&P Bank ETF – KBE) accounting standards will result in loss of faith in the financial sector’s worth.

From Mark-to-Market to Mark-to-Make-Believe

There was a time when banks loved the Mark-to-Market accounting model, because it allowed them to showcase truly miraculous real time profits. By 2006/07 the financial sector accounted for over 40% of S&P 500 earnings.

Things changed in 2007/08. Mark-to market was unpopular with banks because it would have shown enormous real time losses. Bankers preferred to hide their balance sheets, along with the Federal Reserve and Congress too.

Bankers lobbied the Financial Accounting Standards Board (FASB) to change the fair market accounting rule – rule 157 – but the FASB resisted. Changing fair market or Mark-to-Market was a free pass that practically required no write-downs ever.

However, via the Emergency Economy Stabilization Act of 2008, Congress gave the SEC the authority to suspend Mark-to Market accounting. FASB rule 157 was suspended on April 2, 2009.

FASB 157 – What Does it Mean?

Since April 2, 2009, banks are basically free to value their toxic assets as they please. This example illustrates how the financial engineering formula works in real life.

Bank ABC holds mortgage-backed assets originally valued at $1,000. After running some proprietary and non-verifiable models the bank determines it will eventually sell the asset for $950. The loss, termed credit loss, is only $50.

However, because of MBS bad rep, the banks portfolio is currently worth only $500. The actual current value ($500) minus the credit loss ($50) is called noncredit loss ($450).

The $450 noncredit loss is recorded on the balance sheet under “comprehensive income,” but is not run through the income statement. Those losses don’t affect earnings, and are excluded from banks’ regulatory capital calculation.

Extreme Financials

The chart below (courtesy of Yardeni Research) illustrates the effect of financials. The worst recession since the Great Depression caused five quarters of extreme earnings contraction followed by eight quarters of extreme earnings growth (yearly growth rates were capped at +100% and -100% due to extreme values).

Was the miraculous earnings recovery due to a fundamentally strengthening financial sector (corresponding ETF: Select Sector Financial SPDR – XLF) or accounting tricks?

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Financials at 22-Month High – What Does this Mean for The S&P 500?

Pssst, no one is talking about it, but one industry sector has quietly climbed to new 22-month highs – Financials. Will their run continue, how can you tell when it’s over and how will it affect the stock market?

The financial media can’t see the forest for the trees or the stairs for the cliff.

So much ink is being spilled reporting Obama’s and Boehner’s latest comments, hints and lunch menu, that the media missed the financial sector’s march to new 22-month highs.

Will financials continue to edge higher, and what does the financial sector strength mean for the S&P 500 and other broad market indexes?

The chart below provides a nutshell summary of the Financial Select Sector SPDR ETF (XLF).

1) Marks the technical breakout from a multi-week trading range. The Profit Radar Report expected this breakout on August 5, when it said:

“Financials are currently under loved. Of the $900 million invested in Rydex sector funds, only $18 million (2%) are allocated to financials. With such negative sentiment a technical breakout above 14.90 could cause a quick spike in prices.”

2) Shows that XLF never broke below the bold October 2011 trend line and never triggered a sell signal.

The strength in financials was one reason the Profit Radar Report maintained that the down side of the post September correction was limited and exited all short positions at S&P 1,348 and S&P 1,371 (and went long at S&P 1,424 last week).

3) Volume over the last couple of days has been solid.

4) RSI is lagging the September 14 high water mark and will be running into resistance. RSI may also set up a longer-term bearish divergence if it isn’t able to beat the September high.

XLF accounts for 15.42% of the broad SPDR S&P 500 ETF (SPY) and has the power to be the tail that wags the dog.

This price/RSI divergence in XLF might harmonize with my expectation for a large-scale market top sometime in Q1/Q2 2013.

There’s a newly formed support line (not shown in chart), which should be used as stop-loss for long positions.

No doubt by the time the media moves the spotlight on financials’ performance, the lion’s share of the gains will be already over.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.

P/E Ratio Based Valuations are Beyond Deceptive

P/E ratio analysis used to be a time-tested, go to valuation parameter. Recent changes however, have turned the P/E ratio into the most deceptive value barometer around. Here’s why.

The P/E ratio is based on profits and only reliable as long as the “P” in P/E are actual profits. In a world where Wall Street thrives on manipulation, do P/E ratios still apply?

To illustrate: Wells Fargo is trading around $33 a share with earnings per share of $3.18 and a P/E ratio of 10.40. This is cheap, isn’t it?

But how do we know that Wells Fargo’s profit is really $3.18 a share?

As of December 30, 2011, Wells Fargo had total assets of $1.313 trillion and total liabilities of $1.173 trillion. You and I don’t know what the assets and liabilities are, and I venture to say that Wells Fargo doesn’t even know.

How much are the millions of homes Wells Fargo financed before the housing bust really worth? Again, we don’t know, but we know that due to an FASB (Financial Accounting Standard Board) rule change, Wells Fargo and every other corporation in the U.S. can now overstate the value of their under water assets.

FASB Rule 157

FASB rule 157 applies to fair value (or mark-to-market) accounting. Fair value is (or used to be) defined as “the price that would be received to sell an asset or paid to transfer liability in an orderly transaction between market participants.”

In 2008 the market turned disorderly and on April 9, 2009, the FASB (strong armed by Congress) changed rule 157 to suspend the fair value rules when the market is unsteady.

Instead of reporting the current value of an asset (market-to-market), corporations are now allowed to pick a price they believe the asset will be worth in the future (mark-to-make-believe).

Cause and Effect

What effect would this have? A March 2009 Bloomberg published this assessment:

“By letting banks use internal models instead of market prices and allowing them to take into account the cash flow of securities, FASB’s change could boost bank industry earnings by 20 percent. Companies weighed down by mortgage-backed securities, such as New York-based Citigroup, could cut their losses by 50 percent to 70 percent, said Richard Dietrich, an accounting professor at Ohio State University in Columbus. ‘This could turn net losses into significant net gains,” Dietrich said.’”

Is that really what happened? Let’s see which companies drove earnings growth for the S&P 500 in 2012.

The chart and data below was compiled by Morgan Stanley’s Adam Parker. According to his research, ten stocks are driving about 88% of the entire S&P 500 earnings growth.

Six (seven if you consider GE a financial stock) of the ten companies belong to the financial sector (Bank of America, AIG, Goldman Sachs, Wells Fargo, JPMorgan Chase, Citigroup).

Without Apple and the financial sector, earnings growth for the S&P 500 would be next to zero. A bad year for Apple and a return to fair value accounting could easily double the P/E ratio.

Based on P/E ratios, does the S&P 500 still look cheap?

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.

Groundbreaking Study – Dividend ETFs are Riskier than the S&P 500 Index

Dividend rich sectors and dividend ETFs are often considered boring and anti-sexy. However, a closer look at past performance shows a surprising twist. The “orphans and widows” deliver more pizzazz and less safety than you’d expect.Investors are scrambling for two things right now: Safety and income.

Safety

Courtesy of the 2008 meltdown stocks lost about 50% and even the persistent stock market rally from the March 2009 low is marred by three corrections of 10 – 20%. Such drops aren’t easy to stomach and retail investors are simply scared of volatility.

Income

The Federal Reserve has publicly stated its objective of keeping interest rates low until 2015 and beyond. This is great for banks and corporations, but investors (especially retirees) are left without income.

The need for income draws many to dividend ETFs. The common perception is that dividend ETFs provide safety and income, but is that really true? Let’s look at the facts.

Dividend ETFs

We will use the iShares Dow Jones Select Dividend ETF (DVY), SPDR S&P Dividend ETF (SDY), and Vanguard Value ETF (VTV) as proxy for dividend ETFs. The current dividend yields are: 3.41% for DVY, 3.14% for SDY, and 2.61% for VTV.

DVY, SDY, and VTV reached their all-time high on May 23, 2007. How did DVY, SDY and VTV handle the 2007 – 2009 stock market crash compared to the S&P 500?

From May 23, 2007 – March 06, 2009 the S&P 500 lost 55.11%. Surely, dividend ETFs should have fared much better, right? Wrong! DVY lost 63.01%, VTV lost 58.59% and SDY slightly “outperformed” the S&P with a loss of “only” 54.83% (see chart below).

Financial Sector – For Better and for Worse

One reason dividend ETFs got slammed by the market crash is their objective of finding dividend paying stocks. The financial sector paid the highest dividends in 2007, 2008, and early 2009.

Financial stocks got hit harder than the broad market. Being focused on dividends during this time was like maxing out your credit card just to earn miles. The cost (or risk) simply wasn’t worth the benefit (or dividend).

Nevertheless, the exposure to financial stocks helped dividend ETFs to a quick recovery in 2009. Although dividend ETFs did a lousy job of preserving their owners capital during the meltdown, they’ve outperformed the S&P 500 Index ever since.

Sector Rotation

From the March 2009 low to the September 14, 2012 high, the S&P 500 was up 114%, DVY gained a stunning 152%, SDY 143%, and VTV 128% (see chart below).

DVY and SDY also did better during the summer 2011 meltdown. Where the S&P 500 lost as much as 21.58%, DVY’s maximum loss was 17.78% and SDY dropped not more than 17.90%. VTV on the other hand fell a whopping 24.30%.

We don’t know the ETF’s top holdings in 2011, but today VTV is the only ETF that still counts financials as its top sector. This probably contributed to the disappointing performance in 2011 (financials lost as much as 36.33% in 2011).

SDY has a 21% stake in consumer staples, which paid off as the SPDR Consumer Staples ETF (XLP) now trades over 20% above its 2007 high. DVY has a 31% stake in utilities and 18% exposure to consumer goods.

Lessons Learned

Who would have thought that dividend ETFs outperform the S&P in an up market and under perform in a down market? Dividend ETFs aren’t bad investment options, but they may not do what “they’re supposed to do.”

Chasing dividend yield rich sectors bears risks, and if you own dividend ETFs solely as a protection against the next sell off, you may want to rethink your strategy.

Big Banks Pity Their Near-Record Profits – Is This Bullish for the Financial Sector?

It’s tough being a banker today. The Federal Reserve wants to buy their bonds for top dollars, profits are near all-time highs, and yet bankers just aren’t happy. Here’s a closer look at the numbers and technicals.

“Mirror, mirror on the wall, who is the richest of them all,” the six big banks ask. The mirror replies: “You are the richest of them all, almost as rich as you were in 2006.” Disappointed about not being the richest ever, the banks walk away to drown their sorrow in a pity party.

The six largest banks reported a combined annual (June 2011 – June 2012) profit of $63 billion. How does this compare to the banks’ all-time record earnings? In 2005 banks earned $68 billion, in 2006 they earned $83 billion.

Banks are depressed because the new regulatory regime crimps their style and proven methods to make money. It requires banks to maintain bigger capital cushions. This limits their appetite for insane leverage and makes it harder to earn an “adequate” return on equity.

Boy, and those low interest rates really make it hard to make money too, they say. Never mind that the Fed pushed down interest rates just to keep the banks alive.

Some of the $63 billion profits (exactly how much nobody knows) aren’t real profits. They are accounting gains, profits engineered by clever accountants. That would explain why the six largest banks announced at least 40,000 job cuts from June 2011 – June 2012.

Perhaps this will give the banks – which are JPMorgan Chase, Wells Fargo, Goldman Sachs, Citigroup, Bank of America, and Morgan Stanley – reason to cheer. According to Bloomberg estimates they are expected to earn in excess of $75 billion in 2013.

Will Financials Rally Further?

The August 5, Profit Radar Report took a closer look at financial sector – the Financial Select Sector SPDR ETF (XLF) in particular – and featured the following research:

“Financials are currently under loved (who can blame investors). Of the $900 million invested in Rydex sector funds, only $18 million (2%) are allocated to financials.

With such negative sentiment, a technical breakout (close above 14.90) could cause a quick spike in prices. Next trend line resistance, and possible target, if 14.90 is overcome, is 15.63.”

As the chart below shows, this technical break out above resistance (dotted red lines) occurred on August 6th. The initial target at 15.63 (outlined by the solid red line) was met and exceeded quickly.

This red line, previously resistance, has now become support. There was no price/RSI divergence at the September 14 high, which suggests at least another run to new highs … another reason to make the bankers happy.

The analysis for the SPDR S&P Bank ETF (KBE) looks nearly identical.

The only way investors can share in the bankers’ (undeserved) joy is to profit from opportunities like this. The mission of the Profit Radar Report is to identify high probability and low-risk buy/sell signals for the S&P 500 and many other asset classes.

Financials – Is the Most Despised U.S. Sector Getting Ready to Rally?

Investors are shunning the financial sector. Although financials account for more than 14% of the S&P 500 (SPY), investors (by one measure) have only 2% of their money invested in financials. Some contrarians take this as a buy signal, is it?

Knight Capital, MF Global, LIBOR fixing scandal, JP Morgan losses, excessive Wall Street bonuses … there seem to be unlimited reasons to dislike the financial sector (Financial Select Sector SPDR ETF – XLF).

When it comes to financials, investors are not only talking the talk, they are walking the walk. Right now financials are the most despised sector in the United States. Of the $900 million invested in Rydex sector funds, only $18 million are allocated to financials, that’s just 2%.

However, the financial sector accounts for 14.21% of the S&P 500 Index (SPY), which makes it the second biggest sector of the S&P (behind technology).

Extreme pessimism often results in unexpected price spikes. Is the financial sector getting ready to rally?

The Technical Take on Financials

Financials appear to be at an important short-term juncture, but let’s provide some long-term context before looking at the short-term.

From the 2009 low to the 2011 high, the financial sector (XLF) jumped from $5.88 to $17.20. Before that, XLF dropped from 38.15 to 5.88. Today XLF trades 61% below its all time high price tag of 38.15. In comparison, the Dow Jones Industrial Average (DJIA) is less than 8% away from its all-time high.

Important short-term resistance for XLF last week was at 14.85. This resistance was made up of the July 3 and 27 highs and a trend line that connects the March 27 and May 1 highs.

On August 8, XLF was able to close above 14.85. Such a break out is generally bullish. However, the volume on which XLF broke out was significantly lower than average (see chart below).

Based purely on the chart and sentiment, the bullish message deserves the benefit of the doubt as long as XLF remains above 14.80. But a break below 14.80 would severely ding the immediate up side potential for XLF.

What about the down side risk? Aggressive investors may decide to sell or go short XLF with a break below 14.80. The initial down side target would be around 14.45 – 14.50.