The other day I wrote an article in which I showed data from various segments of the U.S. economy, which indicated that the economy may be heading into a decline: Is the U.S. Economy In Trouble? Since that article was published two more significant data points have been released, which indicate to me that the economy may be in serious trouble.
First, PC sales dropped worldwide in the 1st quarter by 14%. This was worst quarterly drop in history for PC sales: historical plunge in PC sales. The expected decline was 7%. To be sure, part of this decline is accounted for by the "cannibalizing" of PC sales by tablets and maybe iPhones. But the expected 7% decline would have taken this factor into consideration.
Computer sales are an integral part of the U.S. economy and they are highly correlated with consumer spending. As affirmation that the consumer is slowing down, retail sales for March were reported today and dropped .4% vs. the previous month: retail sales tank. The expected decline from analysts was .1%. Even if you strip out gasoline sales, which were lower due to lower prices at the pump, retail sales declined .2%. In addition, although February's gain in sales was revised slightly higher, January's .2% reported gain was revised to negative .1%.
Obviously the trend is showing retail sales in decline. This is especially troubling because, in general, retail sales usually at least show a monthly increase that equals the rate of inflation. These numbers suggest a dramatic decline in sales unit volume, which means consumers are seriously pulling in the reigns.
Historically, consumer spending has represented around 70% of the GDP. If this trend of consumer spending continues to decline, it will mean serious trouble for the economy. I wanted to tie this consumer-based economic data into what it means for bank stocks, because JP Morgan and Wells Fargo both reported earnings today that, of course, "beat" expectations based on the headline numbers but were troublesome below the surface.
For Wells Fargo (WFC), revenue actually declined vs Q1 2012. But more troubling for the country's largest home loan lender was the decline in mortgage revenue. Year over year for Q1, home loan revenue declined 15.5% and declined 12.8% from last quarter: WFC 8-K (pdf). The bank has now seen a decline in home loans for two consecutive quarters as fewer borrowers refinance despite lower interest rates. This is a double-whammy for WFC, as fees from mortgage refinancings and originations slow down, its existing portfolio will be earning less as the Net Interest Margin (NIM) declines - a key quality of earnings indicator for all banks.
For JP Morgan (JPM), earnings came in at $1.59 vs $1.39 expected. However, a look below the headlines reveals that JP Morgan manufactured 29 cents/share by "releasing" $1.1 billion of its loan loss reserves. This is a non-cash GAAP maneuver that banks have been using for the past couple years to "manage" reported earnings. It means that JPM believes that it will have lower loan write-offs vs. the amount it reserved for write-offs. But is this a good assumption given that it would appear as if the economy is getting ready to tank?
In addition, JPM's Net Interest Margin also declined, missing the expected number for its NIM and indicated that its NIM would down a full 1% for the year. This was the 6th consecutive quarterly decline in NIM for JPM going back to Q4 2011. Here's JPM's 8-K (pdf). This is crucial because right now, based on the Fed Funds rate of 0 - .25% and the minimal amount of interest banks pay for deposits, bank cost of funding can not go any lower. But as seen in both JPM's and WFC's earnings, their interest spread earned on loans is declining and loan volume is declining. This is ominous for future earnings.
Given the dramatic slowdown were are seeing in consumer spending and the implications for the economy, and given that this slowdown in economic activity will directly affect bank earnings, I would recommend avoiding taking any long positions in any bank stocks. In fact, for more aggressive traders, given that the outlook for JPM's and WFC's future earnings appears like they will be below what is expected by their current stock market valuations, money can be made by shorting either stock or buying out of the money puts. For the latter I would recommend going out to August or September in order for analysts estimates to catch up with the analysis I presented above.