Low Expectations for Investment Banks

Goldman Sachs (GS) reports tomorrow and Morgan Stanley (MS) Wednesday. I own both these stocks as a "barbell" approach to the market - owning some things in places I am not really that positive on - knowing that they can rally at times the rest of the portfolio might dip (which has been the pattern many times since last summer). [Jun 6: Starting to Buy Stuff I Don't Like] That said, combined these 2 make up less than 2.5% of the fund at current time, so it's not much of a barbell. These 2 are the best of an awful bunch - the open question is, as the easy credit days disappear like memories of tech stocks doubling in 2 weeks - what will their eventual business model be?

Myself, I do think there are a lot of international opportunities available (fertile ground) for investment banking in the years to come, and eventually a new generation of suckers will fall for the products these guys like to sell. Further, as their peers fall one by one (shrink or get absorbed into larger organizations but in a shell of its former self), the remaining pie can be divvied up by fewer strong players. Specific to Goldman Sachs, they literally have people placed in most high reaches of government and industry - so they are the pre-eminent mover and shaker... another bonus. Last, expectations are very low - and these are the type of situations that make ratty retail stocks rally 20% on a very bad earnings report, simply because it "beat expectations". Unfortunately, and this is a problem for our entire financial industry is, the lack of transparency in balance sheets - everyone is guessing what everyone owns and since it's impossible to ascertain (some believe many CFOs don't even realize what they own since many of the instruments are so illiquid and haven't traded for months on end, hence cannot be priced) - so unlike a widget maker it's impossible to have a clue on what earnings might be. [Oct 16: Goldman's "Blowout" Quarter]

Thanks to reader msb, for highlighting this specific article via Fortune. I was writing back in September how these investment banks are black boxes and how it is impossible to gauge what exactly is going on as they have so many levers to pull and push - how could we really tell how they are doing?

I did not realize the depth of level 3 pricing which in layman's terms means stuff that is so illiquid (meaning there is no true market for it), that "computer models" from within the firm actually determine their price. So there is no conflict of interest there and no 'fudging' I am sure. Further, I did not realize that UNREALIZED gains could be counted in a quarter? So if I have paper gains in my stock account for quarter 2, I can count those against my losses? Hmmm, that doesn't really work too well in my Ameritrade account because the next day those gains could evaporate - but I guess it works for Wall Street.

WSJ: Wall Street Goes from Sweet to Sour

• Goldman Sachs Group and Morgan Stanley look like the last two kids on the tour of Willie Wonka's chocolate factory. The investment banks are due to report fiscal-second-quarter earnings this week, and they'll have less company than usual. Historically, four bulge-bracket firms have reported in mid-June, with Merrill Lynch coming a month later. This week, only Goldman and Morgan offer meaningful reports.
• Their numbers are dwindling like the children in the Roald Dahl story and later movies. The kids succumb to the temptations of candy and pay a price. For the investment banks, it was credit.
• Analysts expect Goldman -- the beloved Charlie Bucket of the bunch -- to report earnings of $3.42 a share, down 31% from a year ago. Morgan Stanley is expected to earn 92 cents a share, down 59% from last year. Analysts have for weeks slashed estimates for both firms, citing the same problems that dogged Lehman, including lousy trading revenue and fire sales of assets to reduce leverage.
• Write-downs will likely keep coming as firms keep selling assets, giving bean-counters fresh price tags for what's still on the books, and as the housing downturn and sluggish economy hurt other loans. That could mean more capital-raising, possibly including stock sales that dilute existing shares.
• Meantime, the lucrative structured-finance business is on life support. Deal-making and stock-underwriting aren't feeling much better. All will recover eventually to one degree or another, but until they do brokerage profits will suffer.
• The recovery could be slowed if regulators force investment banks to hold more capital -- a likely consequence of getting access to Federal Reserve loans.

Reuters: Analysts See Lower Q2 Earnings at Investment Banks

• Wall Street analysts have forecast a huge drop in second-quarter earnings for Goldman Sachs Group Inc (NYSE:GS - News) and Morgan Stanley (NYSE:MS - News), while Lehman Brothers Holdings Inc (NYSE:LEH - News) is expected to post its first-ever quarterly loss, mainly on hedging losses.
• "Business conditions appear to be among the worst in several years, bulk asset sales have provided price transparency that should trigger more asset write-downs, and hedging was noticeably less effective," David Trone, an analyst at Fox-Pitt Kelton, said in note last week. (but other than that, things are going swimmingly)
  
• "In the current quarter, it appears that the brokers have not judged risk appropriately once again," Ladenburg, Thalmann & Co analyst Richard Bove said. "The hedge is not working," wrote Bove, who had nearly a year ago recommended that investors sell financial stocks as credit market problems began.
• In the second quarter, investment banks are also expected to incur further losses on "Alt-A" paper, even as writedowns across all other asset classes are projected to be lesser than those in the past quarters. "Alt-A" loans are usually given to those with clean credit histories but who have limited income documentation. (wait, I though 3 quarters ago we were talking about the kitchen sink quarter and it was all up from here? Or was that 2 quarters ago? Or last quarter? I can't keep track anymore, because CNBC and associated pundits have been insisting the bottom is in financials so many times it all begins to blend together)

[Apr 24: Initiating Goldman Sachs]

Long Goldman Sachs, Morgan Stanley in fund; no personal position