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Wall Street braced for earnings backlash
July 6, 2011 / 6:45 PM / 6 years ago

Wall Street braced for earnings backlash

<p>The Wall Street sign is seen outside the New York Stock Exchange, March 26, 2009. REUTERS/Chip East</p>

NEW YORK (Reuters) - Slow economic growth, skittish trading clients and regulatory worries that just won’t go away -- the second quarter has been a punishing one for Wall Street’s top investment banks and their shareholders.

With revenue from trading bonds, currencies and commodities set to have shrunk by a third or more from the first three months of the year, analysts have rushed to downgrade their second-quarter forecasts for big broker/dealer firms such as Goldman Sachs Group (GS.N) and Morgan Stanley (MS.N).

Of 22 analysts providing quarterly coverage for Goldman Sachs, 15 have slashed their earnings per share forecasts since the beginning of June, some by as much as half, according to Thomson Reuters I/B/E/S. Over the same time, half of the 24 analysts covering Morgan Stanley have cut their EPS forecasts.

Average expectations for Goldman’s EPS are $2.89 for the quarter. That’s below the $4.38 the bank earned in the prior quarter, a number that fell to $1.56 after deducting the cost of buying back a stake held by investor Warren Buffett. In the second quarter a year ago, the bank reported EPS of $2.75 before one-time items that cut that number to $0.78.

For Morgan Stanley, average EPS expectations have fallen to 52 cents for the second quarter, compared to 50 cents in the previous three-month period and down from 80 cents a year ago.

Goldman Sachs is due to report interim results on July 19, with Morgan Stanley to follow later the same week.

“I wouldn’t be surprised if the second-quarter numbers are on the weak side,” said Chris Mittleman, chief investment officer at Mittleman Brothers, which manages $75 million in client assets. He says he has stayed clear of Morgan’s and Goldman’s stock because their earnings are too volatile and too dependent on the ups and down of their trading businesses.

Trading, which at Goldman typically contributes more than half of its revenue, has been sidelined by concerns over the pace of recovery in the United States and other big economies, as well as Europe’s sovereign debt crisis. Curbs on trading for the bank’s own account also keep a lid on revenue.

“There’s been a lack of engagement, most of it having to do with the increase in macro headwinds,” said Barclays Capital analyst Roger Freeman, who has long held a “neutral” rating on Goldman Sachs and Morgan Stanley, but says there is value in the stocks for investors willing to wait longer for it.

Commodities, which were good for most banks at the beginning of the year, likely lowered earnings in the April-June period. Oil prices alone fell more than 10 percent in the quarter.

“We believe commodities trading was particularly challenging during the second quarter as the sharp and persistent decline in asset prices may have hurt dealers with long inventory positions,” Credit Suisse analyst Howard Chen told clients in a note.

Investment banking activity was mixed, with a strong run of initial public offerings boosting fee income. Completed mergers and acquisitions were higher than in the prior quarter, but the volume of announced deals fell from the first quarter for the first time in more than a year, Thomson Reuters data show.

CLOUDS OVER WALL STREET

The biggest cloud hanging over Wall Street remains bankers’ and investors’ uncertainty over the extent and long-term effect of major financial reforms being hashed out by regulators after the meltdown of the global financial system in 2008.

The rules are being written, and policymakers have yet to figure out how to curtail the excessive risk taking that is widely seen as contributing to the financial crisis. Already, banks such as Morgan Stanley and Goldman have pared back on trading for their own accounts, on which they staked big parts of their balance sheets in the past.

New global rules on capital mean that banks will have to keep bigger reserves to guard against trading losses, making it even tougher to earn the kind of double-digit returns on equity that investors have come to love.

“Valuations are pretty compelling right now, but there are some issues that need to be resolved before the values can be unleashed, prime among them proprietary trading,” said Keith Davis, a buyside analyst at Washington, D.C.-based firm Farr, Miller & Washington, which manages $730 million in assets.

Goldman’s return on equity, a key measure of profitability, fell to 12 percent at the end of last year from 23 percent at the end of 2009. Before the crisis, Goldman reported returns on equity as high as 33 percent in 2006 and 2007.

“People aren’t convinced that the companies will be able to earn as high a return on equity going forward,” said Mittleman.

EXTRAORDINARILY CHEAP TRAPS

Goldman Sachs shares, down 20 percent this year, last week hit a two-year low. Morgan Stanley shares are down 15 percent. That contrasts with the Dow Jones Industrial Average .DJI, which is up 8.5 percent since the start of 2011.

“Right now the financials are value traps,” said Harry Rady of Rady Asset Management in San Diego, California, which manages $270 million. Rady says it is too early to buy Goldman or Morgan Stanley despite their “extraordinary” low values.

Meanwhile, banks are cutting jobs and other costs to boost their bottom lines. Goldman, for example, hopes to slash $1 billion in non-compensation costs in the next 12 months, and plans 230 layoffs over the next few months. The axe is falling elsewhere on Wall Street too.

Still, some analysts think banks are worth a second look.

“Time to make some money,” the often pessimistic Richard Bove, a Rochdale Securities analyst, told clients last week.

He cited an improvement in the Greek sovereign crisis, Bank of America’s (BAC.N) move to settle mortgage-related litigation and a recent uptick in commodity prices among factors that could spur a summer rally in bank stocks. Bove rates Morgan Stanley a “buy,” but has Goldman stock on a “sell” rating.

His conclusion: “Buy a bank stock today.”

Additional reporting by Lauren Tara LaCapra. Editing by Robert MacMillan

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