Discover leads financial stocks higher, but is trouble lurking?

Key Points

• Discover, Berkshire Hathaway and JPMorgan Chase are leading the financial sector's recent performance.
• Discover gapped down on January 19 after reporting a 59% earnings decline and an increase in its reserve for late payments. 
• Institutional investors sent the stock higher in the past five sessions, as a Citi analyst said it's time to buy the dip. 

Bank stocks and other financials tracked in the Financial Select Sector SPDR Fund NYSEARCA: XLF are rallying to two-year highs, with Discover Financial Services NYSE: DFS among the leaders. 

Heavily weighted sector components Berkshire Hathaway Inc. NYSE: BRK.B and JPMorgan Chase & Co. NYSE: JPM are the best performers over the past five sessions, giving the sector a lift.

During that time, financials lagged only consumer discretionary stocks and technology stocks, both reliable growth sectors carrying 2023's rally into this year. 

Discover initially gapped down on January 18 after reporting fourth-quarter results. Investors zeroed in on a 6259% decrease in quarterly earnings per share, as well as an increase in the amount set aside to cover credit card delinquencies. 

The company said the 30+ day delinquency rate for credit card loans was up 3.87% in the fourth quarter. The personal loan charge-off rate was also higher. 

Can consumers keep up with their payments?

All of that adds up to worry about consumers' ability to continue paying their debt. Much of shoppers' recent spending has likely been on credit cards, driving 3.3% economic growth in the fourth quarter, much better than the 2% growth analysts had forecast.   

Discover is a good barometer of what's really happening with consumer spending, and its report didn't paint a pretty picture of what's going on. Higher interest rates seem to be taking a toll on households, but with the promise of a pause in rate hikes, or even rate cuts, is the situation as bleak as it seems? 

Is interest-rate optimism the reason Discover began rallying on January 19 and has posted gains every day since, as you can see on the Discover Financial Services chart?  

Rate cuts could eventually help consumers better service their debt, but could also have the effect of decreasing the profits of Discover and industry peers like Visa Inc. NYSE: V and Mastercard Inc. NYSE: MA. 

Analysts forecast the stock's price rising

For a glimpse into why Discover has been leading the financials sector, even to the point of gapping up more than 2% in the January 25 session, take a look at the Discover Financial analyst forecasts. 

Analysts' consensus rating is "moderate buy," with a price target of $111.94, an upside of 7.91%. 

If you dig a little deeper, it gets more interesting: Since the fourth-quarter earnings report on January 18, after the bell, six analysts downgraded the stock or lowered their price targets. None of those, however, lowered the stock to "reduce" or slashed their price target below where Discovery shares are currently trading. 

Citigroup analyst Arren Cyganovich told Barron's the clarity on credit losses, the resumption of share repurchases and the potential sale of Discover's student loan business is keeping Citi as a buyer. 

Cyganovich said he considered the stock a buy on the post-earnings dip.

Buying into weakness

Five sessions in a row of upside trade in Discover indicates institutional buyers are indeed scooping up shares on weakness.

The Citigroup analyst cited share buybacks. Discover paused that program in mid-2023, amid an internal investigation regarding student loan servicing practices and related compliance matters.

The buyback program was reinstated in November. Share buybacks can boost a stock by signaling managers' confidence in its financial health and future prospects. 

By reducing the number of outstanding shares, earnings per share often increase, attracting investors seeking higher returns.

Track record of dividend increases

In addition, Discover Financial has a spot on MarketBeat's list of dividend achievers, with a 13-year track record of boosting its shareholder payout.

Discover's dividend yield is 2.7%, higher than the yield of the broader financial sector.

The institutional buying that's been going on in recent sessions shows that enough investors believe there's potential in this stock. Worth noting: Earnings are expected to resume growth this year after declining in 2023, although analysts have revised their targets lower. 

Bigger rivals Visa and Mastercard haven't seen the same earnings decline in recent quarters as Discover. If investors are considering buying into the credit card industry, the better performance of those two stocks is probably worth a look before Discover.