JPMorgan Chase Still Not Firing on All Cylinders

Management now seems to agree that legal costs are an unavoidable expense for large, complex banks, and we don't expect regulators to ease up on complex systemic banks any time soon. We therefore believe it's prudent to incorporate some level of normalized expenses related to unforeseen issues in our long-term forecasts. Though the exact level is debatable, we note that JPMorgan experienced $4 billion in legal costs over the past two years and an estimated $6 billion related to the London Whale alone--material sums in relation to the company's $20 billion in 2014 income applicable to common shareholders.

Headcount fell by 4% during the year, though compensation declined by only 2%, as the company continued to cut employees in its mortgage business while paying more for performance in the asset management and investment banking segment. We expect that the balance between growing revenue and cost management will be harder to manage as results improve.

Finally, we are not overly impressed with the company's capital return efforts. Though the company returned roughly $3 billion of $4.9 billion in fourth-quarter earnings to shareholders in the form of buybacks and dividends, weighted-average diluted shares outstanding fell by less than 1% during the year. We'd prefer that an aggressive reduction in share count accompany the firm's sizable buyback program.

JPMorgan Chase's fortunes, like those of its peers, still depend to a large extent on rising short-term rates and a steepening yield curve. The company generated a mere 2.14% net yield on interest-earning assets in the fourth quarter, down slightly from 2.2% in the final quarter of 2013. We've long been hesitant to hang our hat on rate forecasts, but there may be room for cautious optimism on this front for the second half of 2015. Falling oil prices, declining unemployment, and consumer deleveraging over the past half-decade may finally be setting the stage for a long-awaited return to normalcy. On the other hand, long-term rates remain at very low levels, providing yet another reason not to bank on rate-driven earnings improvements. For reference, our current valuation incorporates an $8.5 billion increase in net interest income by 2018.

We also caution that credit costs are likely to increase from current levels, offsetting potential improvements in asset yields and operating expenses. JPMorgan Chase provisioned $3.1 billion in 2014--a substantial increase from only $225 million in 2013--even as some lines of business continued to release reserves. We expect recent industrywide price competition in commercial lending as well as tough times in the energy sector to affect results in the commercial and the corporate and investment banking segments in 2015--businesses that produced a $350 million provisioning benefit in 2014.

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