1:44 pm Central Time

The rally in financial stocks that began last week is not yet over, but it is definitely struggling to maintain momentum.  Aside from the SEC's mysterious decision to crack down on "naked shorting," the sector was the beneficiary of good quarterly reports from some large banks like Wells Fargo (WFC).  OK, it wasn't technically "good" news.  But the loss at WFC it was not quite as bad as everyone expected.  By Wall Street logic, that makes it good news. 

Now it emerges that even by this standard, the news was not as good as initially thought.  According to the Wall Street Journal, Wells Fargo cooked the books.  Nothing illegal, of course, but it sure stinks.  Here's what they did: Wells Fargo used to "charge off" bad loans from its earnings when they were 120 days delinquent.  Now they have decided to wait 180 days before letting bad loans show up on the bottom line.  It sounds like a little thing, but for a huge bank like Wells Fargo little things add up to big things.

We hope whoever had this idea gets a nice bonus; with nothing but a few keystrokes he added $265 million to WFC's quarterly earnings.  Of course, the loss will return in later quarters.  Reality hasn't changed.  Those loans are still bad, and nothing the accountants can do will change the facts. 

If Wells Fargo is doing this sort of thing, you can bet others are, too.  Banks naturally have hugely complicated financial statements, and there are all kinds of little "adjustments" that can make a big difference… for a little while.  Eventually the truth comes out. 

3:12 pm Central Time

It's hard to see the future, but we still try.  Over the past few months, we've gazed into our crystal ball time and again.  Sometimes we were right, sometimes not.  But regardless the outcome of our predictions, we usually give you something to think about.  Today is no different. 

What happened today?  The market got a booster shot.  The attending physician was Bank of America (BAC).  This morning, BAC reported higher-than-expected earnings.  Revenue was a record $20.6 billion and CEO Kenneth Lewis announced no plans to cut the dividend.  The market liked what it heard and the sector rose slightly.  However, the indexes did not rise on the news.  This goes to show...

...there still may be reason to worry. 

Let's consider a few things before celebrating the financial sector's short-term recovery.  For one, banks have been severely punished in the past several months.  In the last 52-weeks, S&P Select SPDR Financials ETF (XLF) has lost -41.5% of its value, more than any other broad-based sector.  We should expect an eventual rebound, and one that may bring it closer to the mean return.  But, one good week does not make a bull market.

Second, Freddie Mac (FRE) announced plans to slow purchases of mortgages and bonds.  Keep in mind, FRE  is in the business of buying and repackaging mortgages.  When they say they won't be buying as many mortgages, that's like Wal-Mart saying, we won't be buying as many goods for our superstores.  Likewise, when Freddie Mac doesn't buy mortgages, they are slowing the mortgage business.  This may help the long-term survival of the FRE, but it doesn't help an already-struggling housing sector.  In other words, it's bad news for the market.

Third, Google (GOOG) continues to fall in the aftermath of their missed expectations.  Although we haven't commented on this one yet, it's very important.  Why?  Because, Google's revenue is directly tied to advertising.  When companies don't advertise with Google, it means companies aren't spending marketing money they spent last quarter.  This shows a weakness in the overall economic landscape.  It also sets up Google to be a 'canary in the mine' of the U.S. economy.  If that's the case, we're looking at another tough quarter at the very least. 

Bottom line, there may be more weakness in the pipeline.  Don't just look to positive reports from banks to gauge the overall strength of U.S. equities.  Once banks stop reporting earnings, we could be in for another rough ride for the indexes.  Stay aligned with areas of strength, and you should be able to withstand the storm.

Have a great week.    

3:33 pm Central Time

This morning the financial wires brought 'good' news to a banking sector.  Citigroup (C) boosted the markets as AP/Yahoo reported:

"Citigroup has become the latest big bank to assuage Wall Street's worries about the financial sector, posting a $2.5 billion second-quarter loss that was smaller than the market expected."

Let's think about this for just a second.  For our purposes, let's assume we're talking about another sector, say manufacturing.  If you were CEO of a large manufacturing company and you just informed shareholders your company lost $2.5 billion, what would you expect?  I mean, what would you expect besides an unemployment check?  For one, you would expect your company's share prices to tumble.  When your company just posted a -7.7% loss of their enterprise value, stakeholders would be outraged.  You also might expect the manufacturing sector to also take a hit, since your company could spell trouble for the entire industry.  In short, you would normally expect a $2.5 billion loss to be bad news.

But the market doesn't think that way.  Instead of punishing Citigroup's shares and demanding another head on the platter (Citi CEO Charles Prince resigned last November), the market bought more Citi.  C closed up +7.7%.  The question is, why would this happen?
In the market, it's all about expectations.  Citi exceeded estimates for the first time since October.  Since consensus was a $3.67 billion loss, the market thought they were getting a $1.1 billion bonus.  Not really.  But expectations are what matters when it comes to earnings. When companies beat expectation, this is usually a good thing for companies, even when they lose a lot of money.

In addition, crude oil is finally falling.  Time will tell if the trend continues.  For now, banks are rising on the news, Fannie Mae, Freddie Mac, Wells Fargo, and Citigroup being the chief recipients of the market's good graces.  The broad market was little changed at the end of the day.  Our best guess is the bounce in financials will be short lived.  Monday is a new day without institutional naked short selling for select stocks.  Not knowing what will happen makes it interesting. 

Have a great weekend.