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Bank Earnings as a Market Crystal Ball

Jeff Remsburg

The banks report this week — what their results will mean for the broader market over the next 60 days

This week kicks off the beginning of heavy reporting for Q3 earnings season, and everyone wants a crystal ball.

After all, knowing how earnings will affect market direction is especially top-of-mind right now. That’s because U.S. stocks are walking a bit of a tightrope …

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On one hand, the markets have clawed their way back from this summer’s pullback to being within striking distance of all-time highs.

On the other hand, there’s a looming impeachment, the recent yield-curve inversions, geopolitical tensions, and a new report out today indicating that U.S. retail sales unexpectedly declined last month. Plus, this morning, Chicago Fed President Evans is saying he thinks no more rate cuts are needed this year — despite the markets betting strongly on another cut at the end of this month.

Given this market climate, earnings are especially important. If only we had that crystal ball.

Fortunately, here at InvestorPlace, we have our own version of that — one of the most respected quants in the business, John Jagerson.

Regular Digest readers know that we frequently ask John to run market studies for us. In doing this, John accesses historical market data to identify patterns and trends. Then he uses that information to help make well-informed predictions as to what might happen in the markets going forward.

In today’s Digest, let’s dive into another market study courtesy of John. You see, this week, many of the big banks report earnings. In the past, how they’ve performed has served as a powerful leading indicator, helping predict broad market direction over the next 60 days.

Today, let’s dig into those details and use them to help get an idea as to how the market’s tightrope act may play out … and what that means for your portfolio.

***What to look for when evaluating earnings from the big banks

Jeff: John, how about we start with just a broad overview?

John: Sure. Third quarter earnings reports are on their way, starting with the money-center banks all this week. Citigroup (C), JPMorgan (JPM), Goldman Sachs (GS) and Wells Fargo (WFC) kicked things off on Tuesday.

Overall the data looks better than expected with consumer lending leading the way. However, there were a few cracks in the reports as well. Business lending is shaky, costs are rising, and the yield spread is creating serious headwinds. By the end of the week investors should have a good idea for what to expect in the short-term.

The S&P 500 has been choppy over the last few months, and it is still very close to its all-time highs. The pressure to report expectation-beating profits is high and the risk of a disappointment could turn into a real spoiler. According to Zack’s Research, profits are expected to be down -5% this quarter compared to 2018. Which raises some questions about whether stocks are at a reasonable value.

Jeff: Before we go any further, just to make sure our readers are on the same page, what exactly is a money-center bank?

John: It’s like a traditional bank. They do most of the same things but they also focus on business with governments, central banks, and very large corporations. It’s a subtle difference but think about the large names like Citigroup, Bank of America, and Wells Fargo and you can start to get the idea.

Jeff: Why are these banks good barometers for the broader economy?

John: Because they’re the source of capital for businesses. If a business is growing, they will almost certainly want a lender for short-term and long-term financing. If wages are doing well, mortgage demand will be high and consumers will want greater lines of credit also. If any of that starts slowing or businesses worry that it will slow, it shows up in the banks because financing is at the very start of those other economic activities.

This puts a lot of pressure on the banks to pull a rabbit out of their hat and show that the business environment is improving and higher prices are justified. This is important because year over year declines in bank earnings have a track-record for leading big declines in the market.

Jeff: What’s happened in the past when the banks have disappointed?

John: The last four times the money-center banks and major investment firms reported a year over year decline in earnings, the market dropped significantly or consolidated three out of four instances.

The most recent decline was the fourth quarter of 2017 which was reported in January 2018 just before a 12% drop in the S&P 500.

Jeff: Wait — is this causation or correlation?

John: I wouldn’t go so far to say that the bank reports “caused” the declines, but I would say that the reports revealed the underlying weakness in the market.

(NOTE: John provided the chart below, which shows the performance of the S&P following the last four year-over-year money-center earnings declines).

Right now, analysts expect bank earnings in the third quarter to be above the same quarter last year by a narrow 1.2% which may be enough to keep sentiment steady. However, whether the banks beat earnings from last year is just one part of the equation. The other question is whether the banks will miss analysts’ expectations for the size of the beat in the third quarter.

For example, analysts expected that Bank of America (BAC) would report $0.54 per share for the third quarter. It turns out, this morning, they reported $0.56 — a beat. But had they reported much less than $0.54, we could have seen some big negative moves in the stock.

If a trend of disappointments starts to build across the other bank reports this week, the entire market could be in for some unexpected volatility.

Jeff: So, on that note, let’s pivot to the study you conducted. What did you look at exactly, and what were the results?

John: I designed a study that looked at the market’s reaction to the average surprise or disappointment across the major money-center banks and investment companies since the 2008 financial crisis. I think this can give us a guide for what to expect as we watch the reports stream in this week.

Analysts have a very strong bias towards underestimating earnings numbers. Therefore, in any given earnings season, 70% of companies will “surprise” by beating their estimates and this is even more extreme for the banks and investment companies. It’s rare for the entire banking sector to miss low expectations. So, a surprise didn’t really tell me anything historically. It wasn’t a bad sign for the market, but it wasn’t anything I would consider a buy signal either.

Disappointments, however, are a big deal because it’s hard to miss the expectations of analysts who are already underestimating your earnings. In those cases, if more than 30% of the banks and investment companies disappointed expectations, the market dropped an average of 7% over the next 60 days.

For example, a crush of disappointments that occurred with the 4th quarter reports of 2014 that were released at the start of 2015 triggered a 14% decline in the S&P 500 before the index reached bottom late that year.

Jeff: Okay, so if more than 30% of big banks miss earnings, then history suggests we’ll see a 7% selloff within 60 days. But why just 30% of banks? Why wouldn’t a 7% selloff require, say, 50% or more disappointments?

John: You have to consider the bias toward reporting positive earnings. Imagine that you are an analyst and your clients want your estimates. But you know they will get angry if your estimates are high and the company disappoints. And nobody cares — or they think you are a genius — if you underestimate earnings. Investors hate losses much more than they worry about missed opportunities. So, analysts play it safe and underestimate earnings. Yes, everyone knows this, which is why positive surprises have to be really positive to move the stock much. Whereas, a mild disappointment can send a stock down 10% overnight.

Jeff: Wrapping up, how do you see all this playing out?

John: In my view, there are three different potential outcomes this week. If the banks experience a year-over-year decline in earnings, which is very unlikely, all bets are off and I wouldn’t be surprised to see a major correction.

If the banks surprise expectations, investors should consider that a positive for the market, but not the most powerful leading indicator.

The third outcome is what I would like to see the market avoid — the banks see an increase in earnings compared to last year, but they disappoint analyst expectations for that increase. If that happens, the odds for a correction rise considerably and investors may want to add a hedge to their portfolio against a short-term decline.

Jeff: Based on the earnings numbers we’ve seen at this point, how are things looking to you?

John: Given the beats so far, as well as the Bank of America (BAC) report this morning that was above expectations, we’ve probably sealed the deal for this quarter. However, I still want to see how the Morgan Stanley (MS) report comes out tomorrow morning, but it’s looking pretty good.

What is notable is that much of the good news is from consumer loan demand, which is good. However, the bad news is that a lot of what has contributed to the performance is outsized fixed-income trading revenue, which is not a permanent situation.

Also, a few banks including BAC and C have pointed to rising costs, which was a surprise to me and not a great sign for next quarter.

Bottom line: Looking good for now, but there are some issues to monitor.

Jeff: Thanks, John.

As John noted, Bank of America beat this morning. Tomorrow, all eyes will be on Morgan Stanley. If there are any surprises, we’ll let you know. But based on how collective earnings are shaping up right now, it’s “so far, so good.”

For more market analysis from John in his Strategic Trader service, click here. As I write, the average annualized yield from John’s trades is over 25%. Click here to learn more about how he does it.

Have a good evening,

Jeff Remsburg

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