Financial Stocks Wear “Emperor’s New Clothes”

Good Evening;   In what could described as a less than fairly tale ending, the six week rally in both financial shares and the U.S. stock market came to a halt today.  Another dose of economic reality didn’t help, but it seemed that the proximate causes were some so-called “earnings” from Bank of America and a less than flattering appraisal of Citigroup’s recent report.  It’s also quite possible that the rally since March 6 was simply in need of a breather, but today’s 15% drop in the KBW bank index reminded me of the boy who shouted, “But he has nothing on!” while viewing his Emperor’s invisible new clothes.

Other than some typical, post-expiration blahs, I didn’t see any early news that put our stock index futures on the defensive this morning.  Soon afterward, however, Bank of America announced it had tripled its earnings in Q1 versus those it had reported a year ago (see below).  Poorly performing loans rose sharply, and since the numbers were laced with one time gains, including $2.2 billion for a drop in the value of some Merrill debt, analysts and investors alike were unimpressed.  Nancy Bush put it thusly:  “It was a quarter with extremely low quality earnings and climbing credit costs,” said Nancy Bush, an independent bank analyst. “It’s not a healthy picture.” (source: Bloomberg article below).  BAC dropped 25% in today’s trading, finishing on its low tick.

Fanning these early flames among financial names was a report from Goldman Sachs about the equally alarming rise in credit losses at Citigroup.  Citi reported $1.6 billion in “earnings”, but according to Goldman Sachs analyst, Richard Ramsden, C actually suffered an underlying loss of 38 cents per share when the report is stripped bare.  Trading north of $4 on Friday, Citigroup finished Monday with a 2 handle.  With these two financial giants exposed, market participants ran for cover.  Leading indicators, at -0.3%, were a tenth worse than had been hoped, and a rise in the dollar sent energy and materials names to the dungeon.  Just like that — last week’s voracious risk appetites were suddenly sated.

Opening 2% lower, the major averages never once mounted a rally worthy of the name.  Slipping more with each passing hour, most of them closed right on their session lows.   BAC-MER economist, David Rosenberg, makes a fundamental case why the rally into last Friday may have gone too far (see below).  And, after today, the technical picture isn’t exactly a bright one, either.  The 4.3% loss in the S&P 500 was bracketed by a 3.6% drop in the Dow and a 5.6% shellacking in the Russell 2000.  As one might expect during a day when risk is shunned, Treasurys performed quite well.  Yields dropped between 6 and 12 bps across a flattening yield curve.  As mentioned above, the dollar was also sought; it rose nearly 1% against the other fiat currencies.  The currency no central bank can print (gold) also benefited from today’s return to risk aversion, but the rest of the commodity complex fell out of their collective chairs.  A 9% plunge in crude oil was a headline-grabbing factor in today’s 4% fall in the CRB index.

One of Hans Christian Andersen’s more beloved fairy tales is “The Emperor’s New Clothes”.  For those who only remember that “no” could be substituted for “new” in the story, here’s a refresher from the latest Wikipedia entry:

“An emperor of a prosperous city who cares more about clothes than military pursuits or entertainment hires two swindlers who promise him the finest suit of clothes from the most beautiful cloth. This cloth, they tell him, is invisible to anyone who was either stupid or unfit for his position. The Emperor cannot see the (non-existent) cloth, but pretends that he can for fear of appearing stupid; his ministers do the same. When the swindlers report that the suit is finished, they dress him in mime. The Emperor then goes on a procession through the capital showing off his new “clothes”. During the course of the procession, a small child cries out, “But he has nothing on!” The crowd realizes the child is telling the truth. The Emperor, however, holds his head high and continues the procession.” (source: Wikipedia)

This timeless tale comes to mind when viewing the many financial stocks that had until this morning been parading around, hoping not to be seen as similarly draped in fictitious finery.  Each outfitted with the best TARP your taxes can buy, and stitched together with the thread of all but invisible mark-to-fantasy accounting, our nation’s banks have been prancing about to rave reviews ever since the early March memo proclaiming Citigroup’s “profitability” during the first two months of 2009.  Phase one of the resulting liftoff in bank shares was further fueled when other institutions came out and claimed their companies were also profitable using what I then called “EBITDAW” accounting — Earnings Before Interest Taxes Depreciation Amortization and Write-downs. 
The KBW bank index then entered the booster phase of this rally on April 9 when Wells Fargo “pre-announced” stunningly positive earnings.  It helped usher the KBW Bank index to a level that just more than doubled the March 6 nadir.  Now that Citigroup and Bank of America have finally reported, the rally in financial names has ended where it began, with C and BAC.  The actual results are seeing the light of day, and analysts and investors are seeing less to like with each new accounting disclosure.  Whether the sell off we saw during Monday’s session is just some quick profit taking or the start of something more sinister, only time will tell.  Today just happened to be the day someone at Goldman Sachs finally shouted, “hey, these banks really aren’t making any money!”.

— Jack McHugh

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