Investors Hope Bank Earnings Will Prove Recovery Is Real

As big banks start reporting their first-quarter earnings this week, investors will be looking to see if the recent spate of good news suggests a turnaround is for real.

Goldman Sachs kicked off the earnings season Tuesday with earnings that shattered expectations yet disappointed investorsafter the company said it was selling $5 billion in common stock. The capital-raise will help Goldman repay government bailout money but will be dilutive to existing shareholders, sending the stock price lower in after-hours trading.

JPMorgan Chase follows on Thursday, while Friday features Citigroup and General Electric, whose finance arm has been responsible for much of the company's profit woes.

While the news on financials lately has been mostly positive, there's some concern over whether the rally can last.

"What we're seeing right now is a time period where expectations are still pretty negatively biased," says Chris Armbruster, senior research analyst at Al Frank Asset Management in Laguna Beach, Calif. "I think a lot of people are skeptical of the rally, but if you're looking out a couple of years, right now we're sowing the seeds for a very healthy recovery."

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Goldman had been expected to post earnings of $1.64 a share, but instead put up a profit of $1.7 billion, or $3.39 a share. Analysts surveyed by expect JPMorgan to post a 32-cent profit, while Citi probably will lose 37 cents and GE will see a 21-cent profit.

There's some optimism, though, that the results could be a bit better than the dampened expectations.

Wells Fargo Shines Light

Last week's notice from Wells Fargo that the bank's earnings were running well ahead of projections was the latest in a series of indications that the nation's biggest banks had begun to creep out of the shadows of the credit crisis.

Yet few were ready to sound the all-clear siren, with the echoes of the credit crisis still reverberating through the air.

"It's better than a sharp stick in the eye," Uri Landesman, head of global growth strategies at ING Investment Management in New York, says of the turn in the news cycle for financials. "I'm not sure I would declare victory off those numbers, but it's definitely better than saying" things are worse.

Still, with the earnings reports looming and the uncertainty of results from government stress tests, the news from Wells couldn't have come at a better time.

The bank said it was set to report a $3 billion profit for the first quarter, a stark contrast to expectations that most financials still face significant losses in the form of toxic loan assets that still need to get cleared from their balance sheets.

Buying Again, Slowly

Portfolio managers say they've been wading back into financials.

The SDPR Financial Select exchange-trade fund, which gauges the movements of some of the biggest banking-related companies, has edged above $10, a level it has not seen since Jan. 28. JPMorgan Chase comprises 13.6 percent of the XLF, while Wells Fargo makes up about 8.1 percent of the fund and Bank of America is another 4 perccent.

"That's an emotional number for most people," Nadav Baum, managing director of investments at BPU Investment Management in Pittsburgh, says of the XLF's move above $10. Baum owns the XLF, as well as Bank of America convertible preferred stock that can be moved to common shares, and he says the market psychology towards the banks is beginning to turn.

"There are a lot of people feeling that there are still a lot of trap doors in these financials, but they're getting more transparent," he says. "What you're starting to see in these companies is it's not as bad as everybody thought it was going to be."

That's important for the performance of the broader stock market.

While conventional wisdom is that the banking sector likely might not lead the market into another legitimate bull run, most analysts doubt a real rally can happen without the group at least participating. Bank stocks led the market Mondayeven though the broader averages spent most of the day negative.

"They've got to stabilize to keep legs to the market," Baum says. "I'm not so sure it's going to be a leadership issue, but they have to do well."

Enthusiasm May Be 'A Bit Overdone'

How Healthy?

Skepticism, though, remains plentiful about the industry's health.

Many investors still consider the bargain-basement prices on some of the big names as little else than an enticement to make quick moves in and out of positions. In fact, Abby Joseph Cohen, the noted Goldman Sachs analyst, said on CNBC earlier Monday that the firm is encouraging its clients to take on more of a trader's mentalityas it wades through the gyrations of the current market. (see video)

That sentiment is reflected through the industry, as market pros are reluctant to hold the financials for lengthy periods.

"There is a lot of enthusiasm at the moment. To me it seems a bit overdone," says Emily Sanders, CEO of Sanders Financial Management in Atlanta. "We're being a bit overcautious with clients' money and using this opportunity to take some profit and reinvest in fixed income."

Indeed, even Wells' numbers engendered doubts.

Sanders says anecdotal reports she gets from clients who use Wachovia bank--taken over last year by Wells Fargo--indicate instability, and others are worried about how sold the footing is on Wells' foundation.

"It seems like some of the positives that they were able to report were based on the Wachovia acquisition," says Al Frank's Armbruster. "As it's applicable to the other banks, to some extent it is but not completely."

Low lending costs due to aggressive Federal Reserve rate-cutting measures indeed have made it, as Armbruster says, "a pretty good time to be a bank."

Yet he notes that investors shouldn't expect anything dramatic to the upside at least in the near term.

As for the near term, some investors are looking toward the smaller banks, in particular because many community-based institutions are responsible for covering their own lending and haven't farmed out their products to the types of heavily leveraged derivatives that fueled the financials' collapse.

Companies such as Hudson City Bancorp have been popular among those looking for exposure to banks but not the larger institutions. The smaller banks are in better position now to lend and not worry as much about preserving capital, which helps drive income.

"In a way, why shouldn't they" make money? says fund manager Vern Hayden, president of Hayden Wealth Management. "That's one thing that can put banks on a winning track, if they can loan out money and loosen up credit."

And big banks may not be able to get back to normal in that respect until the government stress test passes and there is more disclosure as to the strength of the individual institution's capital positions.

"In financials there are going to be winners and losers, and that is going to be determines somewhat by these stress tests," ING's Landesman says. "You're going to see a group of financials paying off the TARP and things like that and those are going to be the winners. You're going to see those who aren't able or who aren't allowed to do that, and they're going to be the losers."