It’s hard to believe it’s already the middle of July. And yet here we are. As I look forward toward the end of the year, and reflect on 1Q11, here is what I see:

1. The industry is stabilizing. I wouldn’t say we’re recovering yet, but we have stopped the bleeding. Nearly 75 % of the companies in KBW’s bank universe beat or met 1Q2011 estimates, and over half of the companies saw an estimate increase averaging 21 %. Median ROA was 0.65 %, driven primarily by New England and Mid–Atlantic banks, with Midwest and Southwest lagging. However, profit improvement was solely driven by lower provisions, as the industry has meaningfully slowed down reserves allocations.

2. Asset quality is improving. Net charge offs remain high at 0.81%, but continue improving slowly. Using Jefferson Harrelson’s analysis of KBW’s base, NPA inflows are stabilizing system–wide, with new additions to non– accruals averaging around $ 40B a quarter, while total NPAs declining $ 32B over the past four quarters. A good way to look at this trend is using Jefferson’s “Pain Ratio” : Net NPA inflows/PTPP. This ratio should be > 1, especially if you assume that new NPAs will experience a 50 % loss rate, as they have done in the past.

3. Sluggish economy will continue. New home sales have plummeted since peaking in 2Q05, and current inventory of all homes exceeds 2 years. We typically sell 5 million homes in the US annually. We have 3 million available for sale, but also 4 million homes in late stages of delinquency or early stages of foreclosure. The inventory will get worse before it gets better, since 23% of homeowners are underwater in their mortgage, and if prices drop another 5% the number increases to 28%.

4. Industry revenue growth will remain weak until economy improves. We can’t expect NIM expansion until loan demand perks up, despite the steep yield curve. Loan decline system–wide has exceeded $ 200B, and large banks have been impacted less ( 3.7% decline) than the SuperCommunity banks ( 7.2% ). C&I loans have been growing, but as a very low rate. Fee income has been hurt by Reg E, Durbin and the yet–to–be–written regulations. Banks are reverting to abandoned lines of business to make up for the loan shrinkage ( e.g. Regions buying back their credit card portfolio, others reintroducing self–owned credit cards into their product mix, others reconsidering indirect auto, etc. ).

5. Capital parity among all US banks appears closer. SIFI requirements and the emphasis on Tier 1 common equity to risk–adjusted assets will reduce the capital gaps between mega–banks and their smaller brethren. These profound capital level changes will affect the industry by hurting the valuations of large banks, which is ultimately linked to the valuation of all banks. While the Fed did ask for and receive capital plans this January from the largest banks, their assessment of these comprehensive plans is not strictly based on Basel but adds several subjective elements to the mix. We don’t know where the Fed will end up in its requirements, but we do know the number will be higher than it is today. I also believe that this stress testing and analysis might be confined to the largest banks, but will have an effect on the entire system by raising capital expectations across the board. Higher capital requirements overall will dictate lower ROEs which, in turn, will hurt EPS and P/Es given dim growth prospects.

6. Uncertainty regarding performance and capital levels will continue to hurt banks stocks. The market continued to be concerned regarding the uncertainty to earnings from the CFPB and Dodd–Frank implementations. This, coupled with the capital uncertainty, doesn’t bode well for bank stocks.

7. Uphill climb and continued battle fatigue should get the M&A market into high gear again. What stands in the way? Higher capital requirements; overcapitalization among smaller banks today; lingering uncertainty about smaller banks’balance sheet quality, and asset quality in particular; and no expectations for meaningful core revenue growth for most banks. Sellers’ unreasonable price expectations don’t help either. Sellers need to recognize that not all banks are Whitney and Sterling TX, where uniquely strong deposit franchises fetched prize prices. Bank take – out valuations are more likely to resemble the post–credit cycle of the early 1990s (median 1990 – 1994 was 1.5X book) rather than the multiples during the 2000’s (median 2000 – 2007 was 2.2X ).

On the positive side, investors are less confident about banks’ ability to profitably invest the excess capital, thereby exerting subtle pressure on reluctant sellers to monetize the company’s value today.

The next six months will give us more of the same, with minor relief: more regulatory headwinds; more economic uncertainty; continued low rates and sluggish loan demand. Taken all together, this means that the strong will continue to get stronger, while the weak and hurting will face some difficult decisions in the coming months.