What to expect when Morgan Stanley and Wells Fargo report earnings next week

Published Thu, Jul 7 20224:20 PM EDTUpdated Thu, Jul 7 20224:31 PM EDT

Kevin Stankiewicz @in/kevin-stankiewicz-b5593466 @kevin_stank

The latest earnings season on Wall Street is set to kick off in earnest on July 14. That's when major U.S. banks led by JPMorgan and Club holding Morgan Stanley (MS) release second-quarter numbers. Wells Fargo (WFC), another Club name, is scheduled to follow a day later. Here's what you need to know heading into the prints. Big picture Before we get into a preview of what analysts are saying about bank stocks, we want to explain why this upcoming batch of earnings comes at an especially pivotal time for the market. Quarterly results always provide crucial insights to investors — but in this moment, they could answer a major outstanding question for stocks. The set-up goes something like this: Much of the stock market's slide so far this year has been related to what's known as multiple compression, which means stock valuations have declined because investors want to pay a lower price for future earnings. At the start of the year, the S & P 500 traded at nearly 22 times forward earnings. As of Thursday, the S & P 500 traded at less than 16 times forward earnings, even though aggregate earnings estimates for the broad index rose in the first six months of the year . However, Wall Street fears actual earnings could be the "next shoe to drop," a phrase multiple investment strategists have used in recent weeks. They are concerned that stocks could fall further if companies report profits that are lower than expectations and guidance get slashed, too. Here's a basic hypothetical: In January, investors were willing to pay 20 times forward earnings for shares of Company X, which was expected to earn $2.50 per share over the next 12 months. That gives you a stock price of $50. Let's say for a number of reasons, including higher interest rates and geopolitical concerns, the stock dropped to $35 and projected earnings remained at $2.50. That would indicate a 14 times multiple. So, what happens if Company X's quarterly earnings and guidance then came in light and 12-month earnings estimates are revised meaningfully lower to, say, $2 per share? Even if investors are still willing to pay that same 14 times forward earnings, you would get another leg down in the stock to $28. If this happens all over the place, "the shoe" will have certainly dropped, and broader market benchmarks like the S & P 500 could fall under additional pressure. The "E" moving lower — even if there's the same appetite for the stock — would lead to a lower share price. This is why this earnings season is so important, likely offering major clues on where the market goes from here in the near term. Estimate cuts have already started to trickle in, but the actual results from companies could determine whether those cuts dramatically multiply. Now, let's zoom in on the banks. What analysts say A number of analysts in recent days have published their previews for bank earnings; our focus will be notes from Atlantic Equities, Goldman Sachs, Credit Suisse and Baird. (Note: Goldman employs equity analysts that cover other banks, but not their own firm. This is also true in the research division of banks like JPMorgan and Wells Fargo: They cover other banks, such as Goldman, but not their own firms.) In general, all four notes painted a similar backdrop: a tension between the benefit higher rates provides to banks (especially Wells Fargo, JPMorgan and Bank of America ) and general macroeconomic concerns related to the Federal Reserve's ability to tamp down inflation without tipping the U.S. economy into a recession. Throughout the first half of the year, those recessionary worries prevailed and contributed to the weakness in financial stocks. For the likes of Morgan Stanley and Goldman Sachs , a slowdown in investment banking activity has also been a headwind and could show up in quarterly results. Atlantic Equities, which lowered its earnings estimates and price targets on financials, summed it up like this: The banks endured a difficult 1H22 [first half of 2022] following a brief fortnight of strength at the start of the year. The positive tailwind from rising Fed rates quickly succumbed to concerns about runaway inflation and the risks of a hard landing/recession. While the banks themselves are not yet seeing a deterioration in their data, and third-party information indicates that credit quality continued to improve in May, investors have pre-empted the likely increase in provisions from an economic slowdown by marking down the banks. Wells Fargo In three of the four preview notes, analysts highlighted Wells Fargo as one of their top picks or "highest conviction recommendations," which is the phrase used by Credit Suisse. The analysts at Goldman Sachs have a neutral rating on WFC shares. The research firms called attention to Wells Fargo's rate sensitivity because of its large consumer exposure. As rates go higher, banks can make more money on the difference between what they charge on loans and what they pay customers for their deposits. A larger spread, or margin, can boost their net interest income. Analysts generally expect Wells Fargo's net interest income results to be very solid, understandably so given the Fed raised interest rates twice during the quarter (by 50 basis points in May and 75 basis points in June). Plus, Goldman Sachs notes that bank loan growth overall appears to have "actually accelerated somewhat" in Q2 compared with Q1 pace. That would help WFC. However, fees generated by WFC divisions such as wealth management and mortgage could have faced more pressure in the second quarter, according to Atlantic Equities, which lowered its revenue forecasts for both segments. Weakness in the mortgage banking — not just for Wells Fargo, but in the industry overall — was a common theme across all four preview notes. That said, Credit Suisse analysts wrote that they think the softness "should be well understood" by investors at this point, while Baird highlighted Wells Fargo management's warning last month that mortgage banking income could be down 50% quarter over quarter. Another common theme worth calling attention to is credit reserves and whether banks will have set aside money in Q2 to protect against potential loan losses. In more recent quarters dating back to last year, Wells Fargo and peer banks have generally been releasing portions of the reserves they built up during the early part of the Covid pandemic, providing a lift to earnings. For example, in Q1, Wells Fargo decreased its allowance for credit losses by $1.1 billion . However, now that recession concerns are intensifying, analysts believe that large-scale reserve releases are unlikely in Q2. Baird wrote that for the industry overall, it expects "little/no reserve release." Similarly, Goldman wrote the following: "We expect this quarter to mark the transition back from reserve releases to reserve builds given loan growth, although we see the [net charge-off] environment as benign at least this quarter." Morgan Stanley For Morgan Stanley, key questions heading into its earnings release are the investment banking environment and the impact lower market levels will have on asset management fees. These areas are especially important to Morgan Stanley because its two largest reporting segments are Institutional Securities, which includes revenue from investment banking, equity trading and fixed-income trading, and Wealth Management, which includes revenue from asset management fees and net interest income. In fact, Goldman analysts believe Morgan Stanley shares have the most downside risk of the bank stocks they cover because "the market does not appear to have factored in a weaker investment banking backdrop ... and lower market levels impacting [assets under management] and fees in the wealth business." At the same time, Atlantic Equities in its preview Thursday reiterated its overweight rating on Morgan Stanley, citing a range of reasons for their belief that the stock is worth buying for investors with a two-to-three year time horizon. For example, the analysts like the E-Trade and Eaton Vance acquisitions, noting that they help boost earnings stability. That's a major reason we at the Club like those deals, too. Atlantic Equities also highlighted Morgan Stanley's $20 billion buyback program and argued the stock was attractively valued at around 10 times forward earnings. When the Club bought 50 shares of Morgan Stanley on Tuesday , we also called attention to those favorable attributes. Analysts generally expect the recent market volatility to help Morgan Stanley's trading desks, which are significant revenue sources for the bank. In the first quarter, for context, Morgan Stanley's revenue from equity and fixed-income both topped Wall Street's estimates , checking in at $3.2 billion and $2.9 billion, respectively. What's ahead? After Morgan Stanley and Wells Fargo's slated releases next week, Johnson & Johnson (JNJ) and oilfield services provider Halliburton (HAL) are the next Club holding scheduled to report earnings. Those results are set for before the bell on July 19. Two days later, on July 21, life sciences firm Danaher (DHR) is set to release second-quarter numbers. In the last week of July and early August are when the bulk of our companies report. We'll provide a full earnings analysis of every one of our companies as they flood in. (Jim Cramer's Charitable Trust is long WFC, MS, JNJ, HAL and DHR . See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . 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Pedestrians pass a Wells Fargo bank branch in New York, U.S., on Thursday, Jan. 13, 2022.

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