The Independent Market Observer

10/21/13 Revenues and Earnings – Back to Fundamentals

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 21, 2013 11:53:51 AM

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Now that we are entering peak week for earnings reporting, it is time to take a look at what that means for the stock market. We have some data so far, but not much, so I want to defer a detailed analysis to next week. For the moment, let’s look at financials.

I wrote back on June 11 and July 10 about the pressure the financial services industry, particularly banks, was likely to come under and the negative effect that was likely to have. Specific points I made were regulations, capital requirements, more operational scrutiny, slowing mortgage demand, and others.

It is interesting to see how some of these factors are starting to come into play. J.P. Morgan, the poster child for the regulatory aspect, agreed to $920 million in fines for the London whale trading case in September, was reported to have agreed to a $13 billion settlement today over mortgage infractions, and still faces criminal investigation, per today’s Wall Street Journal. Wells Fargo reached an $869 million mortgage settlement earlier this month. Bank of America and Citigroup are also caught up in the fracas. Although this represents past behavior, it will certainly affect future results as well.

Beyond regulatory issues, which are not going away, the underlying businesses are also facing challenges. Overall, the ten largest financial services firms reported earnings that were down 6.9 percent year-on-year while revenues were down 4.8 percent, per Saturday’s WSJ. Wells Fargo revenue was the lowest for the past two years. Mortgage revenue is down as the rise in interest rates has crimped refinancings, while trading revenues have also taken a hit due to relatively quiet markets. Although two of the five biggest financial firms managed healthy increases in net income, all five reported lower revenue on a year-on-year basis.

This matters for several reasons. First, banks are to some extent a proxy for the health of the economy as a whole, so this is a negative signal. Second, these five firms accounted for most, if not all, of the earnings growth last quarter. If they do not carry the baton this quarter, other companies will have to.

The stock market has been very resilient over the past couple of weeks, with the end (for the moment) of the debt ceiling confrontation kicking off a new rally. I think this is in part a relief rally, and I think the belief that the Fed will continue its stimulus also plays a part. What it is not is recognition of fundamental revenue and earnings trends.

Janet Yellen, widely perceived as an inflation dove and therefore more likely to continue stimulus, is now effectively the Fed’s chairperson—which is perceived as positive for the market. The absence of economic data, due to the government shutdown, will also make it harder for the Fed to justify trimming stimulus. Finally, the damage done both by the shutdown itself and also by the ongoing debate over how to determine a federal budget will also be reason for the Fed to continue stimulus. Given all of this, the perception is that the Fed will continue its stimulus and inflate the stock market—and, in this case, perception is turning into reality.

So far, so good, but what we will also potentially see this quarter is the start of an earnings slowdown. Expectations have been marked down so much that we may well see more “beats,” but the absolute levels of revenue growth—or decline—and the waning of many of the tailwinds that have supported the market so far will make continuing that trend more and more difficult. In particular, earnings targets for the next quarter look very tough to meet.

As long as the market continues to trade on the Fed’s support, a serious downturn looks unlikely. When the Fed does start to back off, especially if at that point the fundamentals (i.e., revenue and earnings) are deteriorating, then risk will certainly return. We will know much more about the past quarter in the next couple of weeks and be able to make some more intelligent guesses about this one.

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