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Bank Earnings Will Be Explosive Next Year: Dempsey

Breakout

Financial stocks (XLF) have far and away outperformed the benchmark S&P 500, collectively up 21% year-to-date. Perhaps more impressive, if you look back six months to the start of October, the sector has risen a staggering 40%.

"These were the stocks that were at the epicenter of the crisis, have been on their backs for a long time," says Ed Dempsey, CIO at Pension Partners. "You have a couple of important things going on with the banks. First, in prior periods of reflation, the banks are one of the first to take off, they're most sensitive to reflation."

Dempsey explains that as the rate of asset price decline slows, conditions for the banks improve, mostly due to a potential bottoming in the housing market. He points out that the banks are loaded with dead weight assets, mainly houses.

But the most recent catalyst for the sector came last month when 15 of 19 major financial institutions passed the Federal Reserve's third round of bank stress testing. This literally opened the door for banks to return capital to shareholders with the Fed's approval to raise dividends or buy back stock for those who made the grade.

JP Morgan (JPM) wasted no time in raising their dividend. They actually jumped the gun and announced a dividend hike of 20% and a share buyback plan of up to $15 billion before the Fed had actually announced results.

"That is an incredible signal to market participants," says Dempsey. "What it's saying, at least in the Fed's opinion, the worst of the crisis has passed, the banks which we know are too big to fail, are now allowed to pay dividends."

The importance cannot be understated. In the immediate aftermath of the 2008 financial crisis, the banks were forced to cut their dividends to shore up capital. It was literally a matter of survival. While they survived on TARP, revived and recovered through the following two years, the onset of the European debt crisis in 2010 was yet another blow to the weakened banking system.

Dempsey's case for the banks only grows stronger given the rising yield on the 10-year treasury and longer dated maturities. He says as short rates lower and long rates rise, the banks will capitalize.

"Banks live on the spread. That spread is now getting wider which means bank earnings, bank forward earnings in later 2012 to 2013, have the potential to be explosive."

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