If Goldman Sachs Reports Record Profits, How Will That Affect U.S. Markets?

An article in The Guardian (read the article by Phillip Inman here) reports that Goldman Sachs (GS) projects record profits for 2009. Inman writes:

A lack of competition and a surge in revenues from trading foreign currency, bonds and fixed-income products has sent profits at Goldman Sachs soaring, according to insiders at the firm.

Inman reports further:

Goldman is expected to be the biggest winner in the race for revenues that, in 2006, reached £186bn across the entire industry. While this figure is expected to fall to £160bn in 2009, it will be split among a smaller number of firms.

Barclays Capital (BCS), Credit Suisse (CS) and Deutsche Bank (DB) are among the European firms expected to register bumper profits, along with US banks JP Morgan (JPM) and Morgan Stanley (MS) following the near collapse and government rescue of major trading houses including Citigroup (C), Merrill Lynch, UBS and Royal Bank of Scotland (RBS).

If these projections come to pass, what does this imply for the economy as a whole, and financial stocks in particular? On the surface, one might want to become euphoric about prospects for the rest of 2009 and 2010. Would that euphoria be warranted?

Projection for Goldman Sachs

What would a record profit for GS look like? The following graph shows financial bottom line numbers for GS, 1997 through 2008, taken from the annual reports, except 2009 is projected from first quarter report, annualized:

The projections from the Guardian article are similar to the estimate for 2009 obtained by annualizing the first quarter performance. To get a better comparison, we should look at employee compensation, since the article refers to projected record bonuses specifically. In the following graph we see the average compensation per employee since 1997, showing projected record average compensation based on annualizing first quarter results:

The record average compensation results from projected slightly lower revenues being divided by reduced headcount. The record revenue of $45.99 billion in 2007 was divided between $20.19 billion for 30,067 employees and $17.60 billion retained earnings (pre-tax). The projected revenue for 2009 in $37.72 billion is divided between $18.84 billion for 27,963 employees and $10.52 billion retained earnings (pre-tax). The complete summary financial table is:

Projection for the Financial Sector

The second projection made in the article is for the entire financial sector revenues in 2009 to total approximately $262 billion (£160 billion). It is especially noteworthy that GS is projected to have approximately 14% of financial sector revenues. If same ratio is applied to retained earnings before taxes, this implies $75 billion in “as reported” earnings for the financial sector in 2009.

This compares to “as reported” earnings for the entire S&P 500 estimated to be $205 billion for the full year 2009. “Operating earnings”, which exclude so-called “one-time” charges and are used by many to calculate PE ratios, are estimated to be much higher for 2009, around $397 billion. (These estimates are calculated from the data on the Standard & Poor’s web site here.)

If these estimates are born out, the financial sector will have about 37% of the S&P 500 earnings in 2009. This is somewhat below the peak in the bubble (43%) and way above the pre-bubble average of 23% in the 1990’s. If this is realized, it will be a remarkable change from the 2008 numbers for the financial sector, which were actually negative for the financial sector due to massive fourth quarter write-downs.

However, the above estimate for the entire financial sector may be too high. For one thing, it disagrees significantly with Standard and Poor’s latest estimate. As of June 23, the Standard & Poor’s “core earnings” estimate (“core” = “operating”) for the year 2009 is $55.61 and for the financial sector, $7.19. This assigns the financial sector 13% of total earnings. This is a little more than 2/3 of the 19% obtained using the $75 billion “as reported ” estimate for the financial sector and the “operating” earnings total of $397 billion.

If we use 13%, the total S&P 500 financial sector earnings estimate becomes $52 billion for 2009, of which GS would constitute 20%.

I take two major things away from this discussion. The first is that (1) either GS is far outperforming the entire financial sector, or (2) the S&P estimate for sector earnings in 2009 is way too low. Back in 2006, GS earnings were less than 5% of the S&P 500 financial sector earnings. Could they now be 20%?

The second major takeaway from this is that the accounting changes made to benefit banks in March (eliminating “mark-to-market” rules) have basically had the net effect of turning what would have been “operating” earnings into “as reported” earnings because write downs that otherwise would have been taken were no longer required. Perhaps some of the eliminated mark-to-market write downs would have been greater than needed, but many are merely delayed and will diminish earnings in future years when they become realized losses.

I have the following summary: The banks have merely postponed the day of reckoning and will have to face it in stages in the future. The performance of banks will suffer in the coming years and their stocks will disappoint investors as these long-term drags on profitability are recognized.

Disclosure: The author, family, members and clients own SKF, an ETF which is short financial stocks. This is not a long-term holding, and will probably be removed from portfolios in the coming weeks.

Comments

[herbert hoover:]

How could GS not report record profits? All their losses are underwritten by the taxpayers.

Jun 26 08:30 AM

[Neil459:]

Exactly, GS is the only government program that is working. Unfortunately, its working for GS stock holders, GS employees with bonuses, and the corrupt government officials overseeing the financial crisis but not the taxpayers.

Jun 26 08:47 AM

[Swashbuckler:]

My major takeaway from the article is the author's Disclosure. My opinion is that if he has family and clients in SKF, he's serious. Probably not a bad investment strategy to be flat or short fiancials for awhile. Although I wouldn't load up, at least until the banks start to head south again in a big way.

Jun 26 09:42 AM

[CLH:]

During down turns many companies fail as they should. I consider this a positive. GS is best of breed and a winner. Govt. help is not help but only interference. GS would win either way. The govt. contributes nothing.

Because corrections are a positive, Im positive on the market.

Jun 27 09:02 AM

[DaveW:]

How could anyone post a thumbs-down on this statement?? [Answer: a few GS readers in the audience?]

John, nice piece of writing.


On Jun 26 08:30 AM herbert hoover wrote:

> How could GS not report record profits? All their losses are underwritten
> by the taxpayers.

Jun 27 10:31 AM

[Gregman2:]

Eventually there will be outrage.;-)

Jun 27 11:02 AM

[lazzybum:]

GS is projected to have about the same amount of revenue in 06 and 09. Yet, 09 earning is down by US$4B or 28%. There is no shortage of talent during this down time. Plenty of Wall Street people are looking for jobs. GS may be able to increase its revenue. GS's stock holders will not benefit from it. I'll put my money some where else.

Jun 27 12:15 PM

[Steven Hansen:]

John, did you read the rolling stone article by taibbi on gs about creating bubbles? I am at the airport on my handphone so i cannot get the link.

everything i read now on gs tells of their involvement in everything. if you cannot beat them, buy gs. they may be bigger than our government.

Jun 27 06:10 PM

[Old Trader:]

Given GS's status as "favored son", I have to side with those who find absolutely no surprise in the fact that GS is set to record bumper profits. To a lesser extent, the same can be said of JPM and MS, and I suspect of the foreign institutions mentioned, except their respective nests are being feathered by their governments.

Jun 27 09:58 PM

[Henry Buttal:]

GS' only potential bump in the road last year was AIG...and they clearly manipulated that, thru Government Sachs, to where it literally had no effect, and they had to book no losses or write-downs for the largest blow up in history.

I alternate between outrage and admiration!

Having said that, it is not clear to me if the current GS valuation is getting ahead of the curve even with their now totally dominant future.

Of course, once they renounce bank status, they can up the leverage again and REALLY make a lot o money.

Jun 27 11:12 PM

[ain't no fo...:]

I'm curious - that Treasury Secretary that sat in on the March '08 takedown of Bear Sterns, and the Sept '08 takedown of Lehman and, oh yes, that Sept '08 emasculation of Merrill that has seen their investment bankers all leaving in droves, where was it he worked immediately before he was Treasury Secretary?

Just curious.

Jun 28 12:31 AM

[David Roskoph:]

The world is mathematically bankrupt. So what, who's going to call the debt, God? No, Goldman Sachs.

Jun 28 08:53 AM