Nightmare on Wall Street? Upcoming Bank Earnings Could Rock World Markets

Forget the movies. Forget the roller coasters. This summer’s real excitement: the coming second quarter bank earnings announcements, and their potential effect on world stocks, currencies, and commodities markets.

Having followed all these markets for a while now, it’s a lot like any classic horror or action flick. You know the basic plot, but it can still get you sweating.

Introduction: Chronicle of a Crisis

All major market shifts since 2007 have begun with the U.S. banks. With them the crisis began, with them the rallies began. With them may come the next move down, and only from their true recovery will there arise a genuine recovery. Amen.

Their coming earnings announcements, and the ensuing government responses, are likely to be the economic event of the summer.

Let’s quickly go through a brief chronicle of the crisis:

The current world economic crisis began as a self-inflicted U.S. banking crisis.

The still-alive March rally in stocks and commodities began when the big financial institutions announced first quarter profits. As repeatedly noted by this author and others, this feat required an unprecedented collaboration/conspiracy involving Washington and Wall Street. These profits were not from genuine ongoing operating results likely to be repeated, but were rather a result of a combination of some rather irregular activities, including:

• fabricated hyper-profitable fixed income department trades with AIG, which by themselves were large enough to outweigh the enormous real operating losses
• overstated asset values aided and abetted by bank regulators and the suspension of market to market accounting

When that rally faltered, Washington announced more help in the form of the Public-Private Investment Program (PPIP), another thinly disguised bank welfare program, paid for by U.S. taxpayers. That maintained optimism about the banks, and thus the market, and forced the massive shorts to unwind, thus continuing the low volume meander up to 30% gains.

Within the month, the leading financial institutions on which America depends will announce second quarter earnings. For example, Citibank (C) and Goldman Sachs (GS) are scheduled to announce on July 17th. Rumors and whispered numbers may come sooner. If positive, they will almost certainly be leaked sooner.

Unemployment is already around 10%, well past the bank stress test worst case scenario of 8.9%. That means many thousands more residential and commercial mortgage defaults. Worse, those tests were before GM (GMGMQ.PK) officially rolled over into bankruptcy.

Can Team Washington & Wall Street pull it off again?

Barring some incredible surprise, luck, or creativity (all possible), we think not, and here's what that means:

Scenario 1: Banks Show Losses: Ramifications for World Stock, Commodity, and Currency Markets

Given the above history, if bank earnings disappoint, we can expect some version of the following chain of events: In essence, faith in the fragile, nascent, embryonic world recovery breaks down. From this follows:

A. U.S. stock markets plunge

We get a likely retest of March lows assuming the process hasn't already begun. A brief look at a daily S&P chart (click to enlarge) will show the March uptrend has already been decisively broken.

S&P Daily Chart (courtesy avafx.com)

B. World stock markets follow

They have faithfully followed each other through this crisis, and thus can be expected to continue to do so barring evidence to the contrary. After all, the U.S. is still the major customer of the big exporters, including China. Their economies depend on America. For all the talk at the first official BRICs summit, the BRICs will crack without a robust U.S. consumer market.

Think the world can roll along without a sick U.S. economy? This past week both the IMF and the Paris based Organization of Economic Development (OECD) came out with predictions about the world economic situation. The IMF said things were getting worse. The OECD disagreed. What was the basis for their difference? The OECD believed the U.S. would improve enough to make up for the continuing worsening situation in the rest of its member countries.

C. Commodities Crash Too

The ensuing gloom presumes weakened demand for industrial commodities like crude oil, at least in the short term. Deflation becomes a bigger concern than inflation, so the precious metals become less so.

D. Currencies: JPY, USD, CHF Tend to Rise Against Other Major Currencies

Paradoxically, the U.S. dollar actually becomes a short term beneficiary of the pessimism about the U.S. and world economy. For those who don't follow currencies trading, the USD is considered a safe-haven currency in times of fear or "risk aversion,” second only to the Japanese Yen (and then followed by the Swiss Franc).

For example note how the Euro-dollar currency pair EUR/USD (currencies always trade in pairs, since one currency must somehow be priced relative to something else) has behaved since stock markets were at the March 3rd lows, as depicted on the below daily EUR/USD chart (click to enlarge). Note that we read this combination to mean "Dollars per Euro." Thus the rising price of this currency pair mean more dollars per Euro, the Euro is appreciating against the dollar.

EUR/USD Daily Chart (courtesy avafx.com)

Note how when fear was at its highest in autumn 2008 and in early March 2009, the Euro, and all other major currencies (except the Yen), were at recent lows against the USD. As the March rally has progressed, they've generally gained (except the Yen) against the USD, as optimism fed "risk appetite" and currency traders sought higher yielding currencies.

Here's another example, a daily chart of the AUD/USD. Note a similar pattern.

AUD/USD Daily Chart (courtesy avafx.com)

The Australian dollar tends to behave in an especially inverse manner to the USD. Not only does its central bank pay among the very highest interest rates among the major currencies (unlike the Fed with the USD paying among the lowest), Australia is a commodity export based economy. Thus demand for its exports, and for the AUD, varies with anticipated economic growth more than the USD. So when the world economy looks bad, lower exports are anticipated and traders tend to dump the AUD in favor of the USD and JPY. Whether you agree that these are in fact safer or not, that's how traders treat them.

Scenario 2: Banks Post Positive Results: The Opposite Reaction?

Here's where it gets less clear. The short answer is, it depends how positive. If they somehow show profits from ongoing operations that are likely to continue (no, I don't see how either, but put that aside for the moment), then depending on how convincing their ongoing prosperity is, the recovery is likely to be truly under way. If however, the results are mixed, or, as is so fashionable these days "less bad than expected and thus somehow positive" then the picture is murky.

So What Do You Do?

If the banks were left to themselves, the strong likelihood would be scenario 1. But given that Washington can't let them die, the question really is, how much can Washington still do to minimize the damage?

If you believe in Scenario 1: take profits on stocks; consider some kind of short on stocks (buy puts on the S&P or other indices, Ultrashort Proshares for short term hedging (like SDS on the S&P, SDK on the financials). Currency and commodity traders should short commodities, go long USD, JPY against other major currencies, especially the CAD and AUD.

If you believe in Scenario 2: If the mood is very positive, consider buying stocks, commodities, and the higher yielding currencies (AUD, NZD) or commodity currencies (AUD, CAD) against the USD and JPY.

Disclosure: I have positions in most of the above mentioned investments.

Comments

[doubleshortetf:]

From today's WSJ:

Link for those with account
online.wsj.com/article...

JUNE 29, 2009
Wary Banks Hobble Toxic-Asset Plan

Excerpt - A look at why the U.S.'s toxic-asset program has stumbled underscores how difficult it has been to solve one of the economy's biggest problems: Mountains of bad debt sitting on banks' books.

Jun 29 10:46 AM

[doubleshortetf:]

From today's FT:

www.ft.com/cms/s/0/f77...

Threat to triple A rating of $235bn in CMBS (commercial mortgage backed securities)

Excerpt = Some $235.2bn in bonds backed by commercial mortgages could lose their triple A ratings after Standard & Poor's tightened criteria for rating commercial mortgage backed securities.

It is the latest blow for the commercial real estate sector where prices have dropped about 25 per cent over the past year as the recession has reduced the demand for office buildings, retail store space, hotels and large multifamily flats.

The potential downgrades complicate efforts by the US Federal Reserve to revive the sector, which could cause billions of dollars in new losses for banks who have exposure to commercial loans on their balance sheets.

The Fed is planning to provide investors, such as hedge funds, loans under the term asset backing securities lending facility to buy existing CMBS.

The current Fed plans specify that it will only finance CMBS with triple A ratings.

Jun 29 10:54 AM

[twotraps:]

Interesting article. I think more people need to admit there was and may continue to be heavy involvement from the govt. as Obama ties market confidence to the banks. The earnings were so nuts, I wondered why we needed TARP if everyone was in such great shape!! I tend to agree with the mkt coming off and possibly testing the March lows, but a long range trade could also ensue the low 800's for the S&P. Along with SDS and SDK is anyone watching FAZ...seems cheap given the chance for the banks to pull back.

Jun 29 12:22 PM

[Tom Colangelo:]

Unfortunately, a nth cousin. Never had contact but nice to know somebody made it big.

However, one additional comment on bank profits. There is strong interest by the likes of PIMCO and hedge funds to participate in the PPIP(?) program to buy mortgage assets with FED funding and guarantees. This is the trick in the hat the will allow the banks that do not have great earnings to provide POSITIVE GUIDANCE, thus confounding the general public on whether or not the banks are improving.

One way or the other, they will look good, in my humble opinion.


On Jun 29 01:31 AM Cliff Wachtel wrote:

> Obama already said he won't let big banks fail, and this makes complete
> sense. Show profits? Possibly ,but most of us know the banks are
> in trouble, so it's a real question how much manipulation will be
> allowed, if for no other reason than to preserve credibility for
> when they really need to tell a whopper of lie. thanks for you comments,
> cliff. PS any relation to the Diamondbacks owner?

Jun 29 01:12 PM

[Alessandro:]

For those of you with more research acumen than myself, be wary of rising oil prices that create more profit, which in turn creates more money to invest in propping up the stock market.

Why can't Wall Street see the value in offering consumer incentives to help reduce the almost one trillion dollars in consumer credit card debt?

Want to help turn the economy around, do the OPPOSITE of anything Chase Bank does to its customers.

www.daily-protest.com

Jun 29 03:48 PM

[Kinabalu:]

Todays WSJ showed a chart of the last 8 post-war bull markets and the % S&P 500 price gain before earnings turned up and after earnings turned up. The S&P 500 before earnings turned up gained an average of 26%. After earnings turned up the S&P only averaged an 18% gain. So, the early bird gets a 44% return (26% plus 18%) and the late bird gets 18%. Incidentally, analysts don't expect earnings to turn up until the 4th quarter of this year.

I guess that's why William F. Sharpe concluded that market timers had to be right 74% of the time to beat buy & hold investors.

Jun 29 05:43 PM

[jstratt:]

I appreciate the authors perspective. However banks have had another quarter of huge interest rate spreads that should set the stage for big profits.

My guess is that writedowns will be the big determining factor. On that score the FED, Treasury and Bank Examiners will likely want to move banks back toward realistic asset pricing. Expect writedowns that are substantial but dont shake confidence in the banking system too deeply.

The magnitude of the asset valuation issues suggests to me that we have bank writeoffs for at least couple more years that come in waves dictated by Treasury/FED.

Governments around the world have taken huge risks to save the banks and the banking system. It is hard to believe that they will not force steps back toward realistic asset pricing after delivering another massively profitable quarter of bank profits.

Jun 29 07:37 PM

[Snitzer:]

Made the move, got "in" the markets only to discover I was a month late, the March bottom was past and I was trying to assemble a "thing" on the back of a rally. I have no vision, no ideological agenda, just a desire to ride whatever wave presents itself, and when it falls apart then find another "ride". Should we revisit the March lows then hopefully I'll have enough cash in hand to build further, then await the next wave. There are nascent strategies in mind, but first I need a bigger tool.

Jun 29 09:51 PM

[FloridaBoy2:]

I believe the TARP banks will report Q2 earnings above the expectation. Why? A continuation of the stress test charade to inspire confidence.

Jun 30 06:34 AM

[Cliff Wachtel:]

very possibly, good point. Curious to hear why you think they can continue the charade in the second quarter yet not the third? thanks, cliff


On Jun 29 02:49 AM cameroni wrote:

> Personally, I am taking profits on bank stocks. But only because
> I have no faith in the numbers that are going to come out nor the
> markets reaction to those numbers.
>
> I actually expect better than predicted numbers for this quarter
> but worse than predicted for 3rd quarter results (when it will really
> hit the fan). The big fall is in fall. Try to ignore the nonsense
> that comes out in July. It will all be doped up anyway and is sure
> to discourage the last of the bears who will then capitulate on their
> shorts in exasperation and hopelessness.
>
> That's where the money is to be made.

Jun 30 09:24 AM

[Cliff Wachtel:]

Good points. Hey, what "overly negative rating?" Everyone has been very polite. thanks, cliff


On Jun 29 10:14 AM doubleshortetf wrote:

> Overly negative rating against Cliff and those who agree with him
> (like me) is good contrarian signs that most "fools" believe in scenario
> #2. The same fools who were selling bank stocks like madmen or too
> scared to buy are now ardent cheerleaders.
>
> Yeah just can hear that hissing noise of air leaking from huge bank
> bailout balloon while Hussesin (Obama's real middle name) and Tax
> Cheat Timmy are using tax payers' money to pump it up while talking
> up 2nd pork filled stimulus.
>
> Listen the banks are INSOLVENT based on billions of underwater residential
> and commercial real estates and it'll only get worse as pricing of
> real estate continue to collapse.

Jun 30 09:28 AM

[Buckoux:]

What a load of bullsh*t!


On Jun 28 12:58 PM Michael Boyter wrote:

> What will bring America through this financial crisis and it's lack
> of flowing funds for business's and consumers? The answer is technological
> innovation and good old fashioned competition. I am technology person
> and I believe that money and technology are two separate worlds,
> however they can't live without each other. Technological innovations
> have traditionally driven our country into the leadership role of
> being the "Worlds Trendsetter". What happened? The money followed
> and then was siphoned off by a war, no make that 2 wars, I won't
> get into the book keeping of the wars, or the banking industry due
> to the total destruction of any meaning full regulations to control
> mischief. Now lets get real. If someone has a better mousetrap,
> the world will buy it. If America is to escape the deep financial
> pit we have been thrown into by those who want to privatize the profits
> and socialize the losses, we must make sure that we know the actions
> of industries which produce necessary commodities. Many are allowed
> to police themselves and take at will, due to little if any regulation
> at the expense of our nation and it's future. There is nothing patriotic
> about stealing from your nations future. I grow tired of watching
> them get away with this as we all pay a terrible price for their
> actions. A truth commission is needed. If your afraid of the truth,
> your part of the problem, not the future. Energy and Climate Change
> will be, and should be a the prime issue. This is absolutely necessary
> if America is going to turn a positive new page in our future. We
> must all recognize the path our country needs to follow to return
> to financial respectability. Its a long path. Many industries are
> finding it's easier to get Money to fund " World Changing Technologies
> " from off shore than it is at home in America. What's wrong with
> this picture? Bold and Decisive Action is required. A good example
> is Buzz Aldrin's new vision for NASA. Check it out, he's a man with
> Vision, We need people like Buzz, with a vision for the future,
> who learn from their mistakes to direct our recovery, We need changes
> not the same old actions that brought us here in the first place.
> The "New Age of Clean Affordable Unlimited Renewable Energy" is here.
> America will either assume its rightful place as the leader or she
> will be left behind. I strongly believe that technological advancements
> will once again, bring our great country to the forefront in Innovation,
> and usher in the new age of Limitless Clean Renewable Energy. We
> can, and we will rebuild our economy and make us once again the world
> leaders in innovation.

Jun 30 11:17 AM

[FloridaBoy2:]

Cliff,

Thank for writing the article. IMHO, creative earnings will most likely continue to create confidence. It may be repeated in the third quarter.

I have a B of A business Visa card. I do not carry a balance. The interest rate was raised from 8.9% to 18.99% they are borrowing at close to -0- %. They are making money.

On Jun 30 09:24 AM Cliff Wachtel wrote:

> very possibly, good point. Curious to hear why you think they can
> continue the charade in the second quarter yet not the third? thanks,
> cliff

Jun 30 11:53 AM

[diogeron:]

Inserting the president middle name is not an argument for a thesis, however correct of flawed and that kind of red herring distracts from serious discourse and belongs elsewhere, if anywhere.


On Jun 29 10:14 AM doubleshortetf wrote:

> Overly negative rating against Cliff and those who agree with him
> (like me) is good contrarian signs that most "fools" believe in scenario
> #2. The same fools who were selling bank stocks like madmen or too
> scared to buy are now ardent cheerleaders.
>
> Yeah just can hear that hissing noise of air leaking from huge bank
> bailout balloon while Hussesin (Obama's real middle name) and Tax
> Cheat Timmy are using tax payers' money to pump it up while talking
> up 2nd pork filled stimulus.
>
> Listen the banks are INSOLVENT based on billions of underwater residential
> and commercial real estates and it'll only get worse as pricing of
> real estate continue to collapse.

Jun 30 03:35 PM

[diogeron:]

Of course, I mean the "president's" middle name, if that were not already clear to most readers.

Also, a blanket generality like "...the banks are insolvent" is unhelpful to the discussion and is also untrue. WHICH banks are insolvent? C, Wells, BOA? 80% of banks? 10%? ALL banks?

Jun 30 03:38 PM

[optionsgirl:]

consider doing it with leaps. that way, you don't have to invest large sums and you can use the leverage.


On Jun 29 09:51 PM Snitzer wrote:

> Made the move, got "in" the markets only to discover I was a month
> late, the March bottom was past and I was trying to assemble a "thing"
> on the back of a rally. I have no vision, no ideological agenda,
> just a desire to ride whatever wave presents itself, and when it
> falls apart then find another "ride". Should we revisit the March
> lows then hopefully I'll have enough cash in hand to build further,
> then await the next wave. There are nascent strategies in mind, but
> first I need a bigger tool.

Jun 30 03:48 PM

[j_remington:]

"A CBI survey published yesterday said more than 95 per cent of banks and building societies expected their bad debts to rise over the next few months.

Such write-offs will join the existing "toxic assets" on the banks' balance sheets and make them even less willing to take on riskier lending - the much feared "negative feedback loop".

www.nzherald.co.nz/bus...

Jun 30 04:59 PM

[BPYHO:]

Completely agree. Banks will exceed expectations b/c of cooked books and all the refis. 3rd quarter is when things will start getting more difficult for them. I have been long on FAZ (I know that is not what the 3X are for) but will completely sell off before the banks report and will jump back in when they all report their bogus earnings and FAZ is at 2$ a share....


On Jun 29 02:49 AM cameroni wrote:

> Personally, I am taking profits on bank stocks. But only because
> I have no faith in the numbers that are going to come out nor the
> markets reaction to those numbers.
>
> I actually expect better than predicted numbers for this quarter
> but worse than predicted for 3rd quarter results (when it will really
> hit the fan). The big fall is in fall. Try to ignore the nonsense
> that comes out in July. It will all be doped up anyway and is sure
> to discourage the last of the bears who will then capitulate on their
> shorts in exasperation and hopelessness.
>
> That's where the money is to be made.

Jun 30 09:30 PM

[perceptions...:]

On Jun 28 09:52 AM Cliff Wachtel wrote:

it's all about perception. Cliff

Well, thank you, Cliff!

Seriously now, the banks may or may not be able to continue with their accounting "charades game" for a while longer and with some "assistance"?

That said, the "real economy", housing, Oil, Demographics and a few other issues will ensure that the March lows are revisited, this year!

Jun 30 10:27 PM

[Mark54:]

Excellent (and timely) article on the risk of goodwill impairments on Bloomberg today.
www.bloomberg.com/apps...

Some are really going to feel pressure to write downgood will now that market caps have been depressed for over a 9 months to a year now. Amazing to me that Regions has yet to "come to Jesus" on this one.


On Jun 28 10:42 AM Tack wrote:

> Bank earnings and --more importantly and much overlooked, as of late--
> cash flows are likely to be positive in my estimation.
>
> First, the banks are unlikely to face any major writedown pressures,
> as most bond and mortgage indices, which are often proxies for debt
> valuations, are significantly higher than at their closes in March,
> at the end of the first quarter. This means no mark-to-market hysteria.
> There could even be write-ups, but, probably, the accountants will
> stay on the conservative side.
>
> Second, with the current yield curve at all time high spreads and
> funding available from the government at zero cost, the banks should
> have been taking in the cash in wheelbarrows these past few months.
> Although it would surprise many, who have been misled by all the
> paper writedowns occasioned by GAAP accounting, the banks have been
> solidly cashflow positive, and it's been growing for several quarters.
>
>
> With the banks currently holding nearly $800B in cash reserves, they
> are well fortified for almost any event and particularly well positioned
> for future growth in lending and profits.

Jul 02 11:46 PM