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JBL: Banking on Financials' Earnings

John Layfield

I love earnings season. It's kind of like the Super Bowl; it's put up or shut up time. Also, just like the Super Bowl, there is all this hype and so many times you don't know the real story until it is actually played out.

My wife is a stock analyst; for her, earning season is a nightmare of long hours dissecting what exactly companies are reporting, and what they are trying to hide.

Every earning season generally has some telling events. This one didn't disappoint. However, it is always important to understand why certain companies surpass expectations and why some disappoint. So many times there are outside events that affect a company, and the prudent investor needs to recognize these events; in the current earnings season, that's particularly true for those who own financial stocks.

Bankruptcies Galore

In mid-October the U.S. finally got a more restrictive bankruptcy law. Going forward, it will not be as easy to run away from your debts as it was before. However, the Oct. 31 deadline left a window of opportunity for consumers so inclined to leave their debts with their creditors.

Meanwhile, outgoing Fed chairman Alan Greenspan was set to get the adjustable-rate mortgages out of the economy. The "froth" in the housing market was a direct result of this creative financing; more than one-third of mortgages had adjustable rates. I believe this has and will cause a segmented recession, and those that have already felt the pinch elected to take the easy way out before the new bankruptcy law took effect. I do not think this will cause a recession for the economy as a whole.

This combination of Greenspan's attack on ARMs and the bankruptcy-filing deadline hurt the banks across the board. Bank of America (BAC), my current favorite bank, reported its pretax cost of this bankruptcy window at $667 million, including $143 million set aside for future losses as a direct result of this last opportunity for easier bankruptcies. According to CFO Al de Molina, the bankruptcy related charge-offs and provision accounted for 5 cents per share, just over half of Bank of America's 9-cent-per-share miss.

Bank of America was not alone in this. Among other leading financial institutions:

The next quarter will not feel the effect of this window of opportunity for consumers to take bankruptcy as an easy option. The good big banks are still buying opportunities.

My Favorite Banks

I recommended Bank of America in late October and America Express in mid-December. I still like both stocks. I believe that the big banks are not as susceptible to a flat or inverted yield curve. I believe the regional banks that derive more than 60% of their revenue from spread lending are the ones that are susceptible to the flat or inverted yield curve.

The only conundrum I see is why one anyone would consider a flat or inverted yield curve a conundrum. In 2001, there was $18.5 billion of foreign purchases of U.S. long-term Treasuries. By 2005, that number grew to more than $300 billion. The simple math is that supply and demand will keep long-term rates low. I went to public schools and even I can figure that out.

The only way I see to sharpen the yield curve is to lower rates like Greenspan did in 2001. However, this won't happen soon because of the Fed's desire to limit the adjustable-rate mortgages.

The simple solution to making money in this sector is this; buy the big banks with great growth potential. Bank of America and AmEx still are the best buys in the field. However, stay away from companies that soon will be exposed like the Buffalo Bills in the Super Bowl. I would not recommend Citigroup or any regional banks.

Upon marrying my beautiful stock analyst wife, the only negative was I could not and still cannot sell or buy any stock she covers. I owned shares of Citi and JP Morgan when we got married, and now I am stuck with them because of these compliance issues; otherwise I would own Bank of America and AmEx.

Please Look Away

I believe Johnson & Johnson (JNJ) is a good company. I also believe it wanted to buy Guidant (GDT), the medical device company, to protect its share price. JNJ disappointed with its earnings this week. If JNJ had been successful in buying Guidant, then it could have pointed to its new growth engine to steer scrutiny away from current lackluster earnings performance.

Boston Scientific (BSX) won the Guidant bidding war -- probably overpaying in doing so. I own Boston Scientific and still like it; however, the company just received a warning about quality from the Food and Drug Administration about six of its plants and its recent recalls.

After Friday's 6.57% decline, I think the worst is most likely priced in. I am holding on to my shares; however, I would not be a buyer here until we see how this is going to play out.

Remember, being poor is bad, staying that way is stupid.