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Frederic Ruffy, Optionetics.com
October 9, 2001

Trying to make sense of third quarter earnings won’t be easy.  On the one hand, it has been known for some time that a slowing economy was causing corporate profits throughout most sectors.  At the same time, after the terrorist attacks of September 11, expectations for quarterly earnings in a host of industries have come down even further.  Now, as the third quarter results begin to disseminate, investors will be faced with the challenge of determining to what extent the profit woes stem from long-term factors related to the economy or the short-term factors stemming the terrorist attacks.  Making sense of it all is obviously going to be a difficult task and the best approach is perhaps taking it one industry group at a time.

Bank stocks are often among the hardest hit during times of market turmoil.  For instance, the PHLX Bank Sector Index ($BKX) tumbled 35% during the global financial crisis during the Fall of 1998, compared to a 17% drop in the S&P 500 ($SPX). During the Persian Gulf War, the S&P 500—which is the most popular measure of the broader market—slid 14%, but BKX plummeted 31%.  In short, during periods of market turbulence, bank stocks often fall faster and harder than the broader market.

In this case, some investors expect bank stocks to once again experience above average volatility.  After the terrorist attacks four weeks ago, a number of banks have told investors that their earnings took a direct hit.  For instance, Bank of New York (BK) said that costs related to the attack would take $125 million away from third quarter earnings.  The world’s largest bank, Citigroup (C), estimates that business interruptions, life insurance claims, and other costs related to the disaster will equal $500 million, or ten cents a share in the third quarter.  JP Morgan (JPM) and Bank of America (BAC) also report sizeable losses stemming directly from the terrorist attacks.  

Yet, despite the direct impact of the terrorist attack on bank earnings, share prices have been relatively steady.  Indeed, after tumbling 11.7% in the week following the attack, BKX has been moving higher and the index is less than 4% below its September 10 levels.  While the drop is greater than the percentage loss of the S&P 500, which is now only 2% below its pre-attack levels, given the size of the financial losses incurred by the banks and the extent of the business disruption within the United States, the 4% fall in the BKX is not overwhelming.  

Perhaps the recent recovery in bank shares owes to the fact that investors are looking past the short-term impact of the terrorist attacks.  While third quarter earnings are relevant, what is more important is the long-term fundamental outlook with respect to the banking sector.  On the one hand, according to a Federal Deposit Insurance Corporation [FDIC] analyst, Don Inscoe, “The industry is about as strong as it ever has been.”  The comments came last Thursday at a briefing concerning the impact of the terrorist attacks on the banking industry.  In other words, there is no systematic risk to the US banking system stemming from the terrorist attacks and the industry remains sound.

While the banking industry remains on solid footing, the earnings prospects remain dim, due to the slowdown in the US economy.  For example, slower economic growth lowers loan demand.  In addition, the slower economy has triggered a sharp rise in both consumer and corporate loan defaults.  With trouble in the airline, hotel, and other industries, banks will be forced to deal with more bad loans.  Finally, the rising tide of corporate lay-offs is not going to solve the credit problems facing individuals.  There are long-term factors serving as a drag on banking sector profits and until those are solved, the upside potential in bank shares remains limited.

Therefore, when banks begin releasing earnings reports over the next few weeks, investors will be focused on what the industry outlook is going forward.  At some point, the nine interest rate cuts by the Federal Reserve should have a positive impact on both the economy and profits in the bank sector.  Early signs might come this week when three of the twenty-four components of the bank index report earnings:  Suntrust Banks (STI) on Wednesday, BB&T (BBT) on Thursday, and MBNA (KRB) on Friday.

PHLX Bank Index ($BKX)
Statistics
Implied Volatility	32%
Historical Volatility: 50-day	27%
30-day	33%
20-day	39%
Put-Call Ratio (10/08/01)	.24
30-day Median Put Call	1.62
52-Week High	971.7
52-Week Low	691.5
Price (10/04/2001)	774.5
YTD Return	-14.1%
Average P/E Ratio	16.8
No. of Profitable Companies	24
Number of Components	24
Type of Index	Market Value Weighted
Exercise Style	European

Over the past few weeks, Index Intelligence covered the following indices:

Date	Index	Ticker
08/13/01	S&P 500	$SPX
08/14/01	PHLX Bank Sector Index	$BKX
08/16/01	Dow Jones Industrial Average	$DJX
08/17/01	PHLX Semiconductor Index	$SOX
08/20/01	European-Style S&P 100	$OEX
08/22/01	AMEX Natural Gas Index	$XNG
08/23/01	Nasdaq 100 Index Trust	QQQ
08/24/01	AMEX Pharmaceutical Index	$DRG
08/27/01	PHLX Oil Service Index	$OSX
08/28/01	S&P Retail Store Index	$RLX
08/29/01	DJ Transportation Average	$DTX
08/30/01	PHLX Box-Maker Index	$BMX
08/31/01	Street.com Internet Index	$DOT
09/04/01	PHLX Utility Index	$UTY
09/6/01	Value and Growth	$SVX $SGX
09/10/01	S&P Chemical Index	$CEX
09/17/01	AMEX Airline Index	$XAL
09/18/01	Internet HOLDRS	HHH
09/19/01	AMEX Broker/Dealer Index	$XBD
09/20/01	AMEX Japan Index	$JPN
09/21/01	S&P 100	$OEX
09/24/01	AMEX Oil Index	$XOI
09/26/01	AMEX Disk Drive Index	$DDX
09/27/01	PHLX Gold and Silver Mining Index	$XAU
10/01/01	Mini-Nasdaq 100	$MNX
10/02/01	MS Cyclical Index	$CYC
10/03/01	Oil Service Holders	OIH
10/04/01	Russell Small Cap Index	$RUT

Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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