Bank ETFs: Don't Expect Much Out Of Q4 Earnings

Broadly speaking, big-name holdings in financial services exchange-traded funds, such as the Financial Select Sector SPDR Fund XLF, delivered solid third-quarter earnings reports. Amid election year uncertainty and ongoing speculation about the timing of a rate hike from the Federal Reserve, investors should be cautious about betting on more of the same in the fourth quarter.

Those are external factors that history says XLF does not need to contend with in November, a month in which the largest financial services ETF historically lags the other sector SPDR funds.

“Overall most banks with large loan portfolios reported sequential improvement in loan losses, but Fitch expects losses to deteriorate from currently unsustainably low levels. Median credit losses for the group have been 50-60 bps lower than the FDIC long-term average over the last five quarters,” said Fitch Ratings in a recent note. “Citing a slowdown in growth and broad credit improvement some banks released loan loss reserves this quarter; however, JP Morgan Chase and Citi both built reserves tied to credit quality expectations and growth in consumer portfolios going forward.”

Dow component JPMorgan Chase & Co. JPM and Citigroup Inc C are XLF's second- and fifth-largest holdings, respectively, combining for nearly 16 percent of the ETF's weight.

XLF recently changed in significant fashion with the departure of real estate stocks, which some analysts argue increases the allure of the ETF on valuation.

“More importantly, without REITs XLF sports cheaper valuation multiples. The price-to-book value multiple has fallen from 1.4x to 1.2x, while Return on Equity earnings by firms in the slimmed down XLF is actually a tad higher than previously,” said AltaVista Research in a recent note.

Still, the Fed holds many of the cards relating to the near-term performance XLF and rival ETFs. That is especially true as low interest rates continue weighing on net interest margins.

“Given this persistently low rate environment banks of all sizes have been especially focused on controlling and/or cutting expenses. During the 3Q16 earnings season, many large U.S. banks pointed to new or expanded cost cutting measures to be carried out going forward In general, Fitch believes that many of the easier cost cuts have already been executed on and that incremental savings will be more difficult to produce going forward,” said Fitch.

Disclosure: Todd Shriber owns shares of XLF.