If the pros are right, financial companies will lead the market in the second half of 2005.
According to Thomson First Call, analysts expect earnings for the financial services sector to rise an eye-popping 25% in the third quarter and a still-robust 17% in the fourth. By comparison, earnings for the entire
are expected to rise 15% and 12% in the next two quarters.
Wall Street analysts expect earnings at banks, brokers and insurers to soar in the second half, feasting on a lively mergers landscape, benign monetary policy and a vigorous economy.
It's a rosy scenario and one that should give market bulls reason to cheer as they return from the July Fourth holiday. But it's also a scenario that's fraught with the potential for disappointment, and one that investors should distrust, given the surge in oil and narrowing spread between short-term and long-term interest rates.
For starters, the third-quarter estimates aren't quite as strong as they appear. The third quarter of 2004 was a particularly weak one for the brokerage business and the banking sector, with average earnings rising a modest 3% from 2003. The bar is decidedly low.
It's also worth remembering that the first half of the year has been no barnburner for financials.
In the first quarter, earnings for the financial sector rose 10% compared with the year-earlier period. That was better than most had expected but was in keeping with the broader market.
Not much of anything is expected from financial services companies in the just-completed second quarter. According to the same analysts who predict outsize earnings gains in the second half, the second quarter will be a time of little or no growth for banks and brokers.
Earnings growth will be particularly anemic in the banking sector. Michael Mayo, an analyst with Prudential Equity Group, expects earnings at banks to rise just 2% from a year ago, the slowest rate of growth in three years. The problem for the nation's banks is "sluggish revenue growth,'' something Mayo doesn't see changing soon.
The so-called flattening of the yield curve -- the narrowing spread between short- and long-term rates -- is putting a hurt on many banks. Net interest margins, a way of measuring the profitability of a bank's investment and lending operation, are getting squeezed. Cincinnati-based
, for instance, recently said investors should expect additional margin compression in the quarter because of the "recent negative changes in long-term interest rates."
Some larger banks, meanwhile, are getting hit by poor results from their stock, bond and commodity trading desks. A month ago,
J.P. Morgan Chase
warned investors that it was experiencing a sharp slowdown in revenue from proprietary trading for its own account. A slump in trading revenue was the main culprit behind a 27% slide in second-quarter earnings at
The expectation on Wall Street, however, is that things will turn around in the third quarter. The weakness experienced by financial firms from April to June is said to be a momentary blip that will pass once the
eases up on rates.
Analysts are also looking to a new round of big corporate transactions in the second half of the year and for Wall Street firms to benefit from the fees they earn from advising on those deals.
Bank of America's
recently announced $35 billion acquisition of credit card giant
helped fuel that speculation.
But several trends augur less well for a second-half rebound.
For the past several quarters, a number of banks have been able to fatten their earnings by releasing cash that they held back in reserve to cover bad loans. When the economy is growing, banks typically release funds from these reserves. But in every economic cycle, there comes a point where banks need to keep their reserves in check.
Michael Stead, portfolio manager for River Aire Investment, which mainly invests in financial stocks, says most banks are beyond the point where they can dip into their loan-loss reserves to add to earnings.
And even if the Federal Reserve holds the line on interest rate increases, investors still need to worry about the impact of rising oil pries. For now, the impact on the economy has been minimal. But if gas prices breech $3 a gallon, they could start having a significant effect on consumer spending.
Any slowdown in consumer spending is bad for banks, which are dependent on credit card debt and home lending. A drop in consumer sentiment also would be bad news for stocks and their brokers.
For now, most see little risk of a flattening yield curve. But the spread between short- and long-term rates is getting perilously close to inverting; many economists view this as a precursor to an economic slowdown.
If long-term bond yields continue to drop, even after the Fed stops raising rates, the number of economic doomsayers on Wall Street will start to grow.
None of this to say that financial stocks will become market basket cases in the second half. It's just hard to see the financials being the market leaders.