The Trump Bump: An Earnings Quality Analysis

The “Trump Bump” & Rising Correlations

Though the market appears to be recently dominated by Trump’s potential impact on the American economy, earnings quality trends continue to be relevant to stock prices.

The recent rally since the US presidential election appears to be a broad-based rally, with many different sectors benefiting. However, since the advent of the ETF, more and more often capital is transferred from and to sectors based upon these broad-based funds. As a result, when markets move strongly, the correlation of the underlying stocks tends to spike and the basket of stocks all tend to move together. When ”all boats are lifted,” regardless of the underlying quality of the businesses, this creates over-valued business that investors may want to reexamine.

Vigilant investors and portfolio managers can take advantage of these broad-based movements in the market by monitoring a given company’s underlying quality of earnings. When the share price moves up strongly but the quality of the earnings declines, it may be time to sell a long position, and in some cases put on a short.iscuss firms from four different sectors that have all rallied strongly, especially over the last two months: finance, oil, telecom, and defense. Over the last year, the IYF (financial ETF), IEO (oil ETF), IYZ (telecom ETF), and ITA (defense ETF) have risen by 18%, 26%, 26%, and 21% respectively.

Chart 1

Financials: A Tale Of Bad Loans & Loan Loss Reserves

While the financial sector saw tremendous price appreciation, not all banks were able to grow without a decline in quality. For example, one banking stock that has seen a significant rise in earnings quality risk over the last year is Sun Trust Banks, Inc. (STI).

In the last twelve months, its non-performing loans (NPLs) have risen by 105% year-over-year (YOY). At the same time, the bank’s allowance for loan losses (ALL) has fallen 3% YOY. While the firm remains well-capitalized with an ALL-to-NPL ratio of 1.6x, this is a substantial drop from the ALL-to-NPL ratio of 3.3x last year.

We feel that any analysis of STI should account for the recent rise in non-performing loans. To that very point, if we assume that STI’s ALL account rose in parallel with its NPLs, this would have reduced STI’s trailing 12 months (TTM) earnings before taxes (EBT) by 18%. Instead, STI’s as reported EBT rose 1% YOY to $2.7B.

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Disclosure: Scott Martindale is ...

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