Outlook For Financials Seems Gloomy

By Kevin Grewal

Last year the financial sector took a bath as poor lending decisions forced many to shut their doors, leaving only the fittest to survive.  Many thought the worst was over, but there are plenty of signs to indicate that the sector still remains fragile and faces an uphill battle.

Favorable trends in the sector include a report released by Goldman Sachs (GS) indicating that the current credit-loss cycle in the U.S. financial sector is two-thirds of the way done.  From an aggregate perspective, the total losses that have been accounted for in the U.S. credit markets are at $1.6 trillion of the total expected amount of $2.1 trillion to $2.6 trillion.  Additionally, consumer credit appears to be holding up better than expected as credit card early delinquencies are stabilizing and net charge-offs for securitized loans are declining.

On the downside, the sector, in particularly large banks, is being plagued by a slowdown in growth in securities and the scaling back of lending activities, which have been brought on in order to cover lingering credit losses, non-performing assets and net charge offs.  In fact, a research note published by JP Morgan (JPM) stated that large banks are increasing their cash holdings at a rate of 28% quarter-over-quarter.  A likely result of this shift is a dramatic decline in net interest income which will eat away at profits. 

To make things even worse, in 2010, banks are expected to keep a tight grip on cash and lending, especially in construction and industrial loans, is expected to decline and the costs associated with foreclosure related losses is expected to increase. 

Another unfavorable trend in the financial sector is the increased regulation of derivative trading from the Commodities Future Trading Commission (CFTC) and the higher capital requirements being imposed on certain trading assets.  This makes trading of commodities less appealing and will likely eat away at profits. 

Some equities likely to feel the impact of the aforementioned include the following:

  • Financial Select Sector SPDR (XLF), which is heavily exposed to large banks, in particularly JP Morgan and Bank of America (BAC).  XLF has more than doubled from its March low of $6.18 to close at $14.66 on Wednesday.
  • SPDR KBW Bank ETF (KBE), which is exposed to regional banks. KBE is up 138% from its March low of $9.31 to close at $22.17 on Wednesday.
  • iShares Dow Jones US Regional Banks (IAT), which is focused on small and mid-size regional banks like BB&T Corp. (BBT).  IAT is up 88% from a March low of $11.34 to close at $21.28 on Wednesday.

When considering these equities, it is important to keep in mind the inherent risks involved.  To help mitigate these risks, an exit strategy is important.  According to the latest data at www.SmartStops.net, an upward trend in the previously mentioned ETFs could come to an end at the following price points: XLF at $14.28; KBE at $21.35; IAT at $19.85.  These price points change on a daily basis and updated data can be found at www.SmartStops.net

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