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Big Banks May Hold Earnings Surprises

Citigroup, Bank of America, JPMorgan Chase and Wells Fargo look to have a weak third quarter ahead of them when they report next month, but expectations are so low they may have a chance to surprise to the upside.

"It wouldn't surprise me to see the big banks get a pop, given how ridiculous valuations are right now," says Keith Davis, analyst at Farr, Miller & Washington, a Washington D.C.-based money manager with $700 million in client accounts. "There's a lot of pessimism and negativity built in."

Davis expects most of the earnings to come as the result of "reserve releases," where banks reclassify debts they had expected would not be repaid. While earnings derived from this shell game (rather than growing revenues) have been a big contributor to bank profits over the past year, a report from Deutsche Bank's Matt O'Connor last month argued the weakening economy may slow or even stop that practice in the coming quarters.

Farr, Miller & Washington has been underweight the financial sector against the broader market for the past four to five years. Financial stocks comprise about 8 percent of the market value of the firm's holdings versus their roughly 13 percent to 14 percent weighting in the broader market, Davis says.

Their portfolio typically consists of 30 to 40 stocks, and they own just three financial names: Goldman Sachs, Lazard and JPMorgan Chase.

"They're one of the best-capitalized and best-managed banks out there," Davis says of JPMorgan.

Indeed, capital strength may be the best pitch banks can make to investors at the moment since revenue opportunities appear to remain few and far between. Speaking at a recent industry conference, JPMorgan investment banking chief Jes Staley warned fixed-income trading, a source of strength for the bank in many quarters, would be weak. Analysts polled by Thomson Reuters are looking for JPMorgan to earn $1.02, one cent more than the third quarter of last year.

Sanford Bernstein analyst John McDonald expects trading to be weak at other banks as well due to "the risky macro backdrop," scary headlines and other factors that have caused investors to shy away from risk-taking, he wrote in a recent report. The impact has been particularly negative for the area known as fixed income, currency and commodities.

Some analysts have expressed optimism about mortgage banking. Low interest rates have likely fueled refinancing activity, which should be a boon for several large cap banks, including Wells Fargo, according to a recent report from Citigroup analyst Keith Horowitz.

In the case of Wells Fargo, Horowitz writes that despite its "hold" rating, "the stock is looking more attractive to us on a relative basis than in the past." Still, valuations remain high relative to peers, and Horowitz is below consensus for 2012. Wells Fargo is expected to earn 71 cents per share, according to the consensus estimate, from 60 cents a year ago.

Low interest rates may be good for refinancing activity, but they hurt net interest margins, which represent the difference between banks' cost of capital and what they can charge borrowers. Long term rates have been falling steadily over the past few weeks, and dove further this week as a result of the Federal Reserve's announcement it would buy longer-dated Treasurysmaturing between six and 30 years from now while buying an equal number of Treasurys maturing in three years or less.

A recent report from Evercore Partners argued JPMorgan and Wells Fargo are among the best-positioned for the new environment created by the Fed's policy shift because those banks have "greater top-line diversification and above peer [balance sheet] growth prospects."

For Citigroup, costs will be a key focus as the bank "has disappointed the Street in recent quarters on expenses, and it remains an investor 'hot button' for the stock," according to Bernstein's McDonald. However, McDonald believes the issue should not be looked at in isolation, as revenues have increased more than expenses in certain areas, such as the bank's foreign exchange business. Analysts expect the bank to earn 89 cents per share, from 70 last year.

Bank of America will try once again to give investors some clarity on exposure to mortgage-related costs. Investors will look for additional details on the bank's plans to sell various businesses while eliminating 30,000 jobs over the next few years. But until things are clearer on the mortgage front, the bank's progress in other businesses will likely be a sideshow. Analysts are looking for the bank to earn 20 cents in the quarter, down from a 27 cent gain a year ago.

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