Cracks in the Wall Street Ice - Bull Run Coming To an End?

Observers often view what goes on at investment banks and brokerage firms as a leading indicator for the overall market. When Wall Street is bullish, the thinking goes, share prices can't be far behind. Given that, the relative underperformance of broker-dealer shares so far this year, especially with the S&P 500 testing new all-time highs, suggests that institutional investors see trouble ahead for the sector. Two reports also lend credence to the idea that the Street's -- and the market's -- best days may be behind it. In the first, "Wall Street Gets Bearish About...Itself," the Wall Street Journal notes a rather unusual development that always catches the attention of those at the center of the finance world.

Investors were rattled yesterday when a Goldman Sachs Group Inc. analyst slashed his second-quarter earnings estimates for Bear Stearns Cos., driving shares of the Wall Street firm down more than 3%.

But they may also want to look more closely at the firm that issued the research, and its other rivals, which could be in for earnings disappointments themselves.

For most brokerage firms the second quarter ends next week. The firms have been on fire in recent years, in many cases posting record profits quarter after quarter. Recently profits have been buoyed by robust merger-and-acquisition activity, where firms rake in big fees for advising companies on strategic moves.

Yet this quarter was marked by the continued weakness in the mortgage market, a profit center for the Street. Notably, the appetite for products tied to risky or subprime mortgages has waned. Adding to the misery, the investors who are buying these securities are demanding better terms, which cut into firm profits.

Some business leaders also believe that the current boom in commodities trading, which has juiced results at firms like Goldman and Morgan Stanley in recent quarters, may have peaked.

These concerns are being reflected privately by senior executives at some firms as they prepare to release second-quarter earnings in mid-June. They predict that while firms will still report healthy profits, they will likely be down from the first quarter and in some cases firms may actually miss current estimates, say people familiar with their thinking. This would be unusual as Wall Street firms are renowned for handily beating analysts' forecasts.

"Nobody's seeing any cracks right now," says Anton Schutz, who manages the Burnham Financial Funds from Mendon Capital in Rochester, N.Y. "But when those cracks happen, the dam bursts." (See related Breakingviews column1.)

Mr. Schutz, who has been bearish on brokerage stocks since he sold his stake in Morgan Stanley six months ago, believes that the current euphoria can't last. "They're good companies," he says of the securities firms. "But the gravy train has got to slow down."

The pain this quarter won't be felt evenly. Though most every Street firm trades mortgages, Bear has so far been singled out by the Goldman analyst and others because it is a major player in mortgage securitization -- or the packaging of mortgages so they can be sold to big investors -- and the issuance of new mortgages.

As a result, some analysts are raising questions about whether consensus earnings for Bear's second quarter, which Thomson Financial pegs at $3.67 a share, will hold up. Last quarter it made $3.82 a share.

On May 16, Wachovia Corp. lowered its rating on Bear to the equivalent of a "neutral" from "buy," and the following day Merrill Lynch & Co. analyst Guy Moszkowski lowered his earnings estimates, causing Bear shares to dip below $148, their lowest level since mid-April. But yesterday's bearish note from Goldman's William Tanona, who lowered his original estimate by 22% to $3.20 a share, sent the stock down even further.

Yesterday in 4 p.m. New York Stock Exchange composite trading, Bear shares fell $4.80, or 3.2%, to $147.55. Goldman shares fell $2.86, or 1.3%, to $225.68; Lehman Brothers Holdings Inc. shares fell 86 cents, or 1.2%, to $73.28; and Morgan Stanley shares fell $1.29, or 1.5% to $84.46. Shares of Merrill, which reports earnings on a different timetable, were off $1.21, or 1.3%, to $92.61. So far this year, the Dow Jones Wilshire U.S. Financial Services index is up 1.31%.

Bear, Mr. Tanona wrote, "appears to have borne the brunt of the slow down," a scenario "largely attributable to its broad exposure to slowing mortgage underwriting markets." Mr. Tanona estimates that Bear's mortgage exposure amounts to 40% of its entire fixed-income, or bond, unit, the business for which the brokerage is best known. He wrote that unlike competitors Morgan and Lehman, whose stock underwriting business has actually experienced modest growth, Bear's is down significantly. A spokeswoman for Bear declined to comment, but in a recent investor presentation Chief Financial Officer Sam Molinaro highlighted growth in both the firm's overseas and equities businesses as areas to watch.

Goldman, whose profit often outpaces its rivals, may also be facing a choppy quarter. In a meeting May 16 with Sandler O'Neill & Partners securities analyst Jeffery Harte, two of the firm's top executives sounded a cautious note, according to a research report Mr. Harte issued the following day. (A Goldman spokesman declined to elaborate on the note.)

Firm Chief Financial Officer David Viniar and President Gary Cohn aired concerns about the flagging interest from investors in certain types of mortgage securities. They indicated to Mr. Harte that the subprime weakness is likely to worsen before it improves. They also told Mr. Harte that Goldman is seeing a possible peak in commodities trading, which has been a big profit center for some of the firms. As evidence, Mr. Cohn cited the fact that top commodities traders are now commanding guaranteed pay increases of a staggering 300% when they hop firms.

Already analysts are on the lookout for lower earnings at Goldman. Consensus second-quarter earnings estimates for Goldman are $4.83 a share, according to Thomson, compared with first-quarter earnings of $6.67 a share, signaling that analysts don't expect the string of record results to continue.

Lehman, which, like Bear, is big in the mortgage business, also experienced a drop in profit from mortgage-related business, says a person familiar with the matter. But continued strong investment-banking activity and in other corners of the business, including asset management, could help the firm stay more in line with estimates, which Thomson pegs at $1.84 a share, compared with $1.96 for the first quarter.

Most brokerage stock multiples remain relatively low, with Bear, Lehman, Morgan Stanley and Goldman trading at between 10 and 11 times anticipated earnings for fiscal 2007, compared with 16.4 for the Standard & Poor's 500-stock index, according to figures from Thomson.

Another gauge of value, known as price to book -- stock price compared to the equity available to common shareholders divided by the number of shares outstanding -- ranges from 1.6 for Bear to 2.9 for Goldman compared to an average of 2.25 for the entire group as of yesterday's close, according to analyst figures.

Still, many analysts remain upbeat about the brokerage stocks, particularly Goldman, which has sustained an impressive run in recent years. Of the 20 analysts covering the stock, 12 have some variation on a buy rating, according to Thomson, and eight have "holds," or neutral recommendations.

Sandler's Mr. Harte maintains a buy rating on all the securities stocks and thinks fears of a mortgage-driven business downturn are overstated.

"It's an important business for Wall Street, and the slowdown in mortgage originations is going to weigh on Bear," he says. But "if you look at the equity markets, a lot of deals are going on. There should be a lot more good revenues to come if the cyclical recovery continues to play out."

It doesn't look like investment banks see a slowdown as all that temporary, however. In "Goldman Takes a Breather," a WSJ Breakingviews commentary notes that the Street also seems to be growing more cautious about headcounts, which usually reflects a lot more than anxiety over a short-term hiccup in revenues.

Is Wall Street edging toward a hiring freeze? That may sound like a nutty question given the buoyancy of the markets, boom in buyouts and record investment-banking earnings in the first quarter. But all of this exuberance hasn't stopped rumors from swirling that banks are pulling back on recruiting. Guess what? They're not entirely unfounded.

Goldman Sachs Group is now taking a "pause" on hiring that goes beyond the usual seasonal summer slowdown, according to people familiar with its plans. While the firm will make exceptions for top talent, this is significant. When the market leader makes such a move, you can bet others will follow. If Goldman is a leading indicator, this might become the first industrywide freeze since the tech-stock meltdown.

Nonetheless, taking a breather right now looks sensible. The money industry is enjoying fat times that even its top executives admit will be difficult to sustain. Indeed, take a look at what analysts expect Goldman to mint over the next few years. For its fiscal year ending in November, the firm should earn $21.50 a share, up 10% from last year's record, according to FactSet Research Systems. But in 2008, that's expected to drop to $21.10 a share, and to $19.30 the following year.

So it's understandable that Goldman, and some of its rivals, might ease up on adding new seats. Sure, this means some of the existing staff will have to work a little harder. But given the cost of hiring and buying out bonuses at the top of the cycle, this seems prudent. And, hey, if concerns about a slowdown prove overblown, it's not all bad. The bonus pool won't need to be split with any newbies.

Even though both articles include the requisite measure of spin from optimistic analysts, the fact that industry insiders -- as well as investors in the sector -- are growing cautious at a time when everything is supposedly wonderful suggests the long-running bull party may finally be coming to an end.

Comments

[rolfnorfolk]

I think Michael is right. We've been at this stage before - a determinedly happy song bawled over a sad tune. According to investment managers, it's always a good time to give them more funds. Apart from the noble Buffett, when do they tell you to sell? Before the dot com crash, we had an upbeat presentation from a leading British fund management outfit, explaining that the tech boom was soon to be followed by a super-boom. We hadn't seen nuthin' yet. It was at this point that I began to suspect that the function of broker reps is to repair the cashing-out by their existing, smarter clients with new money from suckers, with the assistance of naive personal financial advisers.

I have launched a new site specifically to promote the views of bears like Mr Panzner, so that my clients and the investing public generally can have fair warning to reconsider their attitude to risk. I've called it "Bearwatch" and you'll find it at theylaughedatnoah.blog...

[Richie]

Shish,

No one anywhere is any good at predicting anything (Earnings, GDP, Market levels etc.)even six months ahead. Of what value is an assessment of when a bull market will end based on anticipated incremental employment levels at brokerage houses two and three years from now!!!

Last time I checked with Warren, he told me that markets cannot be timed by anyone. If this unsubstantiated conjecture is the best you have to write about, perhaps you have too much time on your hands.

[rolfnorfolk]

Well, you're right that timing is unpredictable, which is all the more reason to err on the side of caution. But some kind of prdiction is possible, I think: before I was in the industry I asked my broker to liquidate my investment with him in summer of 1987; I spoke and wrote to clients suggesting switching to cash pro tempore before the Far East debacle in 1997 and switched my wife's pension to cash at the same time; and warned another client to do so with his pension fund in 1999 (he listened, thank goodness). You can't get it exactly right, and who would have guessed that the Federal Reserve would throw so much wood on the fire after 2001? The wood's hot now. If you don't believe Michael Panzner, try Peter Schiff and Richard Duncan - the situation is an accident waiting to happen.