Financials in 2011

This past year has been interesting for financials. After the recession in 2008, bank rescues and profits led markets to recovery in 2009 as writedowns on bad loans began to slow and lending activity resumed.

This past year has had a number of twists and turns as the post-mortem of the financial crisis has come with increased bank capital requirements, reform legislation, fraud investigations, lawsuits and a whole range of issues causing share prices of financials to remain range-bound since early April. The uncertainty surrounding many of these matters kept investors on the sidelines.

What is the true earnings power of these institutions going into 2011? Given the restructuring that took place, especially in the U.S., some of the major profit engines of these banks and brokerages have been eliminated. With prop trading activity and credit card fees being limited or restricted, financial institutions are relying more on advisory and traditional lending services. The good news is financial activity has picked up both in the U.S. and Canada, so non-interest income is expected to rise in 2011. Further, non-interest expenses are at attractive levels as banks have become more efficient, which bodes well for higher pretax earnings power in 2011.

Interest income and margins, however, are likely to remain challenged so long as interest rates remain low. However, as loan volumes increase with the improving economy, so will rates. But in Canada, loan growth remains sluggish, and with rates expected to rise, this could pressure Canadian banks a bit more than their U.S. counterparts. For these reasons, banks with diversified income streams are best hedged against these issues. The largest boon to bank earnings in 2011 should be the continued stabilization and reduction of loan losses and delinquencies, which have slowed over the past year — a trend expected to continue. Over the past 25 years, improvement in loan loss ratios has been critical in determining earnings for banks and even more relevant than changes in revenues. Any continued improvement in these metrics should increase earnings per share and ultimately share prices for banks.

Lastly, bank capitalization has improved considerably over the past two years; much of the federal emergency funding given to U.S. banks has been repaid. This should clear the way to resuming dividend payments and increases for U.S. banks in 2011, which will draw income-minded investors back. This could also impact Canadian banks as U.S. investors may now shift assets to U.S. banks.

We currently favour Bank of Nova Scotia (BNS) and CIBC (CM) shares. CIBC shares have fallen recently but have held support. Royal Bank (RY) shares have broken below their support levels and have much more overhead resistance. While we like TD due to its diverse business, we’d like to see some additional follow-through off of the recent bounce from the 200-period moving average, with a breakout being marked above $75.

In the U.S., Bank of America (BAC) has been the poster child for many of the issues described earlier. It has been on a steady downtrend since April but with some of the legal issue overhang being removed, it is looking increasingly ripe for purchase. Above $12 would signify a break in this current downtrend. It remains oversold technically, and cheap from a valuation perspective (book value and based on projected normalized earnings).

Citibank (C) recently got out from under U.S. government reign and may take some time to get back in the good graces of investors. Above $5 the stock will become more appealing to institutional owners and we expect dividends to resume in 2011. C shares are in a current uptrend.

Our last pick is JP Morgan. It has a strong franchise but remains stuck below its 200-period moving average. If it can get back to $42 on some healthy volume, then the trend should continue higher; it is also in an uptrend.

If these large banks work for investors in 2011, it would mean great things for the broader market. We’ve had a relatively nice rally without significant participation from banks. Should financial start to pitch in next year, the S&P could easily stretch to 1350.