This Big Financial's Earnings Will Affect Its Peers This Week

Ask most investors who follow the markets, and they'll agree that earnings season begins when Alcoa reports its results today. The start of earnings season is a very important time to watch your favorite sectors and stocks, as the early reporters can give you clues regarding what you can expect to see over the coming weeks.

For instance, if one retailer reports reduced spending by teenagers, you can safely bet that other retailers who depend on teenagers are feeling the effects as well. 

In the financial sector, JPMorgan Chase  (NYSE: JPM  ) will be the center of attention this week when it becomes the first major financial to report its earnings on Friday. Let's take a look at what you should watch for, and how situations specific to JPMorgan could create a nice buying opportunity in other financials.

Expectations: numbers and beyond
JPMorgan is expected to report earnings of $1.27 per share for the third quarter on revenue of $24.2 billion, which would be a drop from last year's numbers of $1.40 per share on approximately $25.9 billion in revenue. There is a big wildcard that will be intensely watched during the report, and that is the effect of various legal settlements on JPMorgan's bottom line.

Recent developments
One of the market's biggest concerns here is specific to JPMorgan. A recent report suggests that the company's third-quarter earnings could be wiped out because of settlements and other charges related to massive trading losses. It seems like almost every other day, there's another liability that pops up for the company.

In the past few weeks, the company entered into a $920 million settlement over the "London Whale" hedge trading mishaps and another $369 million in settlements over what is being called "illegal credit card practices." These were both relatively small in comparison to the $6.2 billion loss from the trading mishap itself, and as a result, the stock didn't move much. 

The company also has another settlement hanging over its head, related to allegations of mortgage abuse leading up to the housing crisis. Don't rush to blame JPMorgan, as most of the alleged offenses were committed by Washington Mutual and Bear Stearns, which were both acquired by JPMorgan during the financial crisis.

Sources close to the matter have said that this settlement could be as high as $11 billion in all, which is a completely different ballgame than the other recent settlements. Using the current consensus earnings-per-share projections (see below), we can calculate a projected profit of about $4.8 billion for the quarter. Assuming the company has legal reserves of $4 billion to $6 billion as projected by Deutsche Bank, it is easy to see how an $11 billion legal charge could be serious trouble for JPMorgan.

Other reports have come out suggesting that the settlement could actually end up being much less, about $3.5 billion, because of a dispute with the FDIC over losses at Washington Mutual. Now, $3.5 billion and $11 billion are two very different amounts, and they will have profoundly different impacts on the company and its profitability.

The ripple effect
Whether it is fair or unfair, sectors seems to be very reactive to the fortunes and misfortunes of their peers. For instance, American Eagle Outfitters reported a disappointing quarter recently, and other clothing retailers all tanked -- even ones with completely different target demographics and product types. 

So, if JPMorgan's earnings are adversely affected by all of these settlements, what banks should you watch for a discount?  I think the most reactive will be companies like Citigroup (NYSE: C  ) and Morgan Stanley (NYSE: MS  ) , which are already trading at tremendous discounts to book value and are both very reactive to financial sector drama.

Citigroup trades at just 0.9 times its tangible book value,which shows that the market hasn't really restored its faith in the company just yet. Morgan Stanley trades right at its tangible book value. To put this in perspective, up until 2008, both companies were trading at much higher premiums to tangible book, especially in Citigroup's case.

Generally, companies trade at a discount when the market is pricing in extra risk, which makes them very sensitive to perceived weakness in the sector. A bad result from the first big financial company to report earnings could be the catalyst that causes these to drop a little further -- and create an even better buying opportunity for us. 

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