The Next Leg Up

A couple weeks ago a reporter asked me about my views regarding the upcoming 2Q earnings season.  He wanted to know if corporate America, in the aggregate, will surprise to the upside, to the downside, or not all.  My answer was the same as it always is when asked that question this late in the game.  Corporate management teams have a long and consistent track record of exceeding their guidance, if only by a little.  Given the fact that the quarter had already ended when I was asked the question, I said that individual companies have had more than adequate time to reset expectations, if need be, rather than blindsiding investors with a negative earnings report.  And given the fact that the market has been embracing all good news and dismissing most of the bad news in recent months, I said it was likely that stocks would respond in somewhat favorable fashion to these earnings “beats.”  As my partner John Washington likes to say, “Trends always last longer than you expect.”  Still, I was careful to say that the next significant leg up for stocks is likely to be elusive unless and until some key conditions are met.

The second question he posed required a bit more thought.  He wanted to know if there were any particular industry sectors that deserve close attention as bellwethers for the business sector and economy at large.  After careful consideration, I told him that the banks might provide the most insight during the second quarter.  However, this insight would come in the form of guidance for the future rather than any rear-view summary of the second quarter.  Bank management teams are just as capable (read: guilty) of “sandbagging” as management teams in other sectors.  The real insight, I said, would be the commentary that bank executives like Jamie Dimon would provide about the future operating environment.

First some brief background.  Bank stocks performed very well both leading up to and immediately after last year’s presidential election.  In fact, the KBW Bank Index rose over 50% from late June to early December last year.  Following that move, though, the 24 bank stocks included in that index have teetered above and below flat, in aggregate, while the S&P 500 has made fairly steady gains and is up nearly 10% so far in 2017.  The weak relative performance of late has continued since the banks started reporting earnings last Friday.  Bank earnings are now rolling in fast and furious, and the results are decidedly mixed.  One thing has become pretty clear, though, as we listen to conference calls discussing the second quarter performance.  That one thing is that future earnings growth, and the next leg up for bank stocks, will be heavily dependent on factors outside of management control.

To illustrate my point, I’m including an excerpt from the JP Morgan conference call, which took place on Friday.  The excerpt was taken from a CallStreet transcript posted on Factset.  Here is the question from Saul Martinez of UBS:

“If I can follow up with a bigger picture question and, Jamie, you’ve been, and correct me if I’m wrong, you’ve been pretty vocal about believing that the underpinnings of our economy are healthy and strong and not buying into the whole secular stagnation argument. But at what point does political dysfunction and political paralysis really start to dent that confidence? Because you’ve also indicated that we do need structural reform to lift trend growth, whether it’s infrastructure, tax reform, whatever it is. And can you just comment on that?  And I guess as an adjunct to that, what are your conversations with clients like? Is there a risk that is materializing that clients are also starting to become more frustrated with the lack of progress politically?”

And here is Jamie Dimon’s response:

“I would look at it the other way around. So since the Great Recession, which is now eight years old, we’ve been growing at 1.5% to 2%, in spite of stupidity and political gridlock, because the American business sector is powerful and strong and is going to grow regardless. When people wake up in the morning, they want to feed their kids. They want to buy a home. They want to do things the same as American businesses. What I’m saying is that it would be much stronger growth had we made intelligent decisions and were there not gridlock. And thank you for pointing it out because I’m going to be a broken record until this gets done. We are unable to build bridges.  We’re unable to build airports; our inner city school kids are not graduating.

“I was just in France. I was recently in Argentina. I was in Israel. I was in Ireland. We met with the Prime Minister of India and China. It’s amazing to me that every single one of those countries understands that practical policies that promote business and growth is good for the average citizens of those countries for jobs and wages, and that somehow this great American free enterprise system, we no longer get it. And so my view is that corporate taxation is critical to that, by the way. We’ve been driving capital and bringing it overseas, which is why there’s $2 trillion sitting overseas, benefiting all these other countries and stuff like that. So if we don’t get our act together, we can still grow. It’s unfortunate, but it’s hurting us. It’s hurting the body politic. It’s hurting the average American that we don’t have these right policies. And so no, in spite of gridlock, we’ll grow at maybe 1.5% or 2%.

“I don’t buy the argument that we’ll be relegated to this forever. We’re not, if this administration can make breakthroughs in taxes and infrastructure, regulatory reform, we have become one of the most bureaucratic, confusing, litigious societies on the planet. It’s almost an embarrassment being an American citizen traveling around the world and listening to the stupid (expletive) we have to deal with in this country. And at one point, we all have to get our act together or we won’t do what we’re supposed to do for the average Americans. And unfortunately, people write about this thing like it’s for corporations. It’s not for corporations. Competitive taxes are important for business and business growth, which is important for jobs and wage growth. And honestly, we should be ringing that alarm bell, every single one of you every time you talk to a client.”

Dimon is clearly frustrated that eight years after the recession ended, the economy still won’t go into high gear.  He also seems frustrated, and rightfully so, that he has little power to do anything about it.  He, and many other bank executives across the nation, are all waiting on factors outside their control.  What are these factors that will be most critical in driving bank earnings, bank returns on capital and bank stock prices going forward?

  1. Fiscal stimulus, to include lower corporate and individual tax rates, repatriation of corporate cash held overseas, and large-scale public infrastructure investment;
  2. Bank regulatory relief, to include lower capital and liquidity requirements, fewer restrictions on lending, and fewer restrictions that inhibit market liquidity;
  3. Higher interest rates, which will be determined, to some extent, by the removal of Fed policy accommodation; and
  4. Faster economic growth, which will likely be a function of success on 1, 2 and 3. 

It seems pretty clear that bank stocks are currently in a holding pattern, held hostage to forces largely out of management control.  The same could be said for the stock market at large, which is why we think the banks are a good bellwether for the second quarter.  Like it or not, the next leg up for stocks will likely result from action on Capitol Hill.  So for the time being, we are comfortable with our exposure to the Financials sector.  Incorporating valuations, the risks and rewards appear evenly balanced.  We have been disciplined and purposeful in our allocation to the sector.  And as always, we will continue to research current and prospective positions closely in an effort to uncover opportunities.