Early Earnings Surprises

In our July 1 email blast, we speculated that after a nearly 100% rise in the S&P Financial Index from the March 9, 2009 lows, further strength in the overall market may have to come from a different sector(s). Well, as of right now, we’re wrong. As I write, the S&P 500 is now up 1.5% for the third quarter (thanks to today’s rally of about 3%), with Financials performing the best of the ten S&P 500 industry groups. Financials are up 5% in today’s trading and are now up over 3.5% for the quarter. It would appear that risk is once again in vogue after a modest 7% pullback in the S&P 500 from mid-June to July 10.

So what’s driving all the renewed euphoria? The answer is earnings from two very large bellwethers: Goldman Sachs and Intel. According to some, the positive earnings news doesn’t end with these two behemoths. From a article by Whitney Kisling of Bloomberg today: “Earnings have topped estimates by an average 20 percent for the 16 companies in the S&P 500 that have released second- quarter results since July 8, according to data compiled by Bloomberg.” Given that Intel beat the consensus estimate by 125% and Goldman beat by 39%, however, we wonder how much of the buying celebration can be attributed to the smaller, less significant companies that have reported earnings so far in the quarter. Johnson & Johnson may be an exception, but that company only beat the consensus estimate by 4%. It’s pretty clear to us that investors are looking at Goldman Sachs and Intel as harbingers of a very positive earnings season.

Are the optimists correct? We think they may be half right. Intel’s guidance for higher-than-expected revenue on stronger chip demand may indeed signal that pent-up demand for technology products and services will lead to better corporate earnings in that sector. However, Goldman Sachs’ blowout quarter should not be viewed as a signal of strength in the Financial sector at large. Goldman’s blowout quarter was the result of its positioning as the preeminent trading and investment banking firm on Wall Street, operating in a very favorable environment. Goldman posted quarterly revenue records (which is saying a lot!) in its Fixed Income, Currencies and Commodities (FICC) segment, its equities trading segment, and it equity underwriting segment. While these results are encouraging (and we own Goldman Sachs stock), we are not sure how sustainable these results may be. From an article in today’s Wall Street Journal: “Analyst David Trone of Fox-Pitt Kelton Cochran Caronia Waller LLC told clients he expected Goldman’s results to be “far weaker” during the second half of the year due to a smaller deal pipeline, less demand for corporate-debt issuance and the end of the big bank capital raises following the government stress test results this spring.” We agree that this type of favorable environment won’t last forever for capital markets firms like Goldman. But perhaps more importantly, Goldman Sachs has virtually no exposure to consumer credit, which continues to rot as the unemployment rate marches toward 10%.

Other banks will most certainly benefit from the current positive trading and investment banking environment. We are likely to get better-than-expected results from the likes of JP Morgan Chase, Morgan Stanley, Bank of America, and even perhaps Citigroup. However, the vast majority of “banks” within the S&P 500 Financials index continue to suffer mightily from soaring credit costs, which are likely to spread from consumer mortgages and credit cards to commercial mortgages and other loans. The cycle is clearly not over, with many analysts speculating that another round of capital raises will ultimately be required. While it may or may not get as bad as the doomsdayers project, it is pretty clear that the nuts-and-bolts business of making loans is not making money right now. We’d prefer to see some light at the end of the tunnel before getting on this bandwagon.