Financial Stocks & the Law of (Not So) Great Expectations
Research Director, Mad Money
From: Nicole Urken
Sent: Monday, January 02, 2012 6:24 PM
To: James Cramer
From Bespoke: “Wells Fargo the New King of the Street.”
At the end of 2010, JP Morgan was the biggest Wall Street firm in the country. After declining 22% in 2011, JPM gave up its top spot to Wells. And, Wells at $146bn market cap is bigger than Bank of America ($55bn),
Goldman Sachs ($46bn) and Morgan Stanley ($29bn) COMBINED.
From: James Cramer
Sent: Monday, January 02, 2012 6:41 PM
To: Nicole Urken
Subject: RE: Wells
The beginning of the end of the international bankers.
From: Nicole Urken
Sent: Tuesday, January 17, 2012 8:30 AM
To: James Cramer
Subject: RE: Wells
We are seeing this today in Wells vs Citigroup!
The latest conundrum: The move in the much-hated bulge bracket banks. Case in point: On Wednesday, we saw Goldman Sachs rally 7 percent after posting better-than-expected earnings, even as uncertainty remains surrounding the company’s go-forward growth drivers and the European debt crisis. On the other hand, U.S. Bancorp—which is among the best-of-breed regional banks and lacks European exposure—was up only 1 percent on Wednesday after posting a positive report. We are seeing this performance dichotomy between the bulge bracket and regional banks again today with Bank of America and Morgan Stanley up nicely (despite ho-hum fundamentals) versus BB&T—another quality regional bank—experiencing muted price action after a solid quarter.
So what gives? The safer, regional banks report strong numbers and barely move while bulge bracket banks, with significant overhangs remaining, shoot up? Two key explanations:
First, investors are starting to see positive signs out of Europe, including strong Spanish and French bond auctions today. There is a feeling among many investors that while Europe is far from solved, it has backed away from disaster-zone territory. Of course, this remains to be seen—but because of this sentiment, many are searching for ‘beta’ (financial jargon for riskier names that can provide more upside). Names like JP Morgan and Goldman have more upside potential if we do see stabilization in Europe.
Second, valuation and expectations. To put it simply: With Goldman and the banks, valuation doesn’t matter… until it matters. All last year, the bull case for the banks was that they have been trading significantly (and unfairly) below their book value. Yet this argument simply hasn’t made a difference, as estimates continued to be cut, and European debt issues remained a macro overhang. However, with Goldman kicking off a series of bulge bracket positive earnings beats, the cheap valuation argument suddenly becomes a reason to buy these names. The bull case now? The quarterly beats mean the stocks are too cheap here. Same argument, but this time it’s moving the stocks. The only difference this time is the reported beats. If, for example, Goldman can perform decently in this environment, improvement in housing and jobs are a powerful combination for the stock and its peers, which have underperformed over the last four years… and this implies valuation is too cheap. In other words, again: valuation doesn’t matter… until it does. In contrast, best-of-breed regional U.S. Bancorp has been trading over 1x its book value and investors see less upside here, despite its solid positioning. Oh, not to mention that Goldman was down 46 percent in 2011 while U.S. Bancorp was flat.
All that said, the email exchange above with Cramer from the beginning of January does still reveal the improved positioning of regional-focused banks—where Wells Fargo is a winner. Wells, which posted a strong quarter, is a strong play on housing coming back, particularly given the many mortgages on its book (and given that its Wachovia portfolio is in a much better position than Bank of America’s Countrywide one—with the remaining legal overhangs). Citigroup earnings report on Tuesday wasn’t enough to prompt a ‘too cheap’ thesis—particularly versus stabilization in Wells that we saw. But the later beat at Goldman—and now Bank of America / Morgan Stanley too—was enough to fuel the group.
This “valuation doesn’t matter until it does” for the bulge bracket banks is, in fact, the exact mirror image of what we have seen with momentum stocks. A sky-high multiple from the likes of Chipotle or Intuitive Surgical hasn’t mattered because these companies continue to exceed estimates in their quarterly reports. But as soon as we see deceleration in earnings from a high-flying stock—like we saw in the tragic case of Netflix last year—the sky-high valuation becomes a liability. Again, valuation doesn’t matter…until it does.
Now, looking at the quarter ahead, the financials are certainly the best example of a group with upside based on beating lowered expectations, given they were the worst performing group in the S&P last year (down 18.5 percent) and their out-of-favor status because of Europe and regulatory scrutiny. That said, this phenomenon of potential stock upside from beating reduced expectations extends to other sectors as well.
For example, we are seeing upside potential for the semi group, which underperformed the S&P by 12 percent last year as earnings were cut by 30 percent—with nearly all of the semis preannouncing negatively at least one time. That is one of the key reasons why on Mad Money we highlighted Broadcom on Wednesday’s show. Broadcom’s leverage to secular wireless growth and market share opportunities are not reflected in the stock—which is a more under-the-radar play than semi wireless darling Qualcomm .
When looking at the broader market even beyond laggards like the financials and semis, reduced expectations could indeed be the impetus for strength in the weeks to come. Through Friday January 6th—just before Alcoa kicked off earnings season—130 S&P 500 companies had pre-announced their fourth quarter results. 99 of those—i.e. about 20 percent of the companies in the S&P 500—were negative pre-announcements versus 30 positive ones, according to Thomson Reuters. This ratio of negative to positive is the largest showing since the fourth quarter of 2008 in the midst of the last recession.
The law of reduced expectations has taken hold of the market, as beats have been strong—albeit off a smaller base. As worst-to-first dominates right now (financials, materials, industrials and tech) based off of reduced estimates, we could continue to see moves higher if the macro stays intact. Oh, and as a side note, if the banks can continue to rally, that’s a plus for upside on the market as a whole, as the group makes up 14 percent of the S&P.