Earnings season gets underway in earnest next week, but later this week we will hear from most of the large banks on the subject of their third quarter results. For some with a somewhat wonkish mindset, this is a great time as there are lots of numbers to comb through and therefore lots of different and often contradictory conclusions to be drawn about the financial sector and the broader market.
For most people, though, bank earnings are mystifying and somewhat frustrating. Post-release stock movement is usually not in response to the normal headline numbers, but to some other metric that is deemed important in that quarter’s results.
A few years ago, when just remaining solvent was the main challenge for many banks, it was “tier one capital” that drove the stocks. More recently it has been trading results, as banks took on more risk. Relative stability and a bullish stock market so far this year have made trading numbers less relevant, however, and a lot of the chatter this time around is centered on something much more fundamental to a bank’s existence: loans.
Focusing on that most basic of banks’ functions may be trendy right now, but it is nothing new to regular readers of Market Musings. I was suggesting as long as a year ago that that metric was the one to watch when banks reported and that it should drive longer term investing decisions, not just for bank stocks but also elsewhere.
The basic function of banks is to take in deposits and use them to make loans. Those loans can be to businesses for start-ups or expansion, or they can be to individuals to finance major purchases, but either way they are an important engine of profit for financial institutions and of growth to the economy as a whole.
Reacting to things like trading desk profits when banks release their earnings makes no sense anyway. They are inherently in the past and have no bearing on future results and, as has been shown on many occasions, one big trading disaster can wipe out years of profitability in a matter of weeks.
A quality portfolio of loans, however, is a gift that keeps on giving, returning steady if unspectacular profits for years on end. Call me old fashioned, but 2008-9 provided enough excitement around bank performance to last me a lifetime and I would much rather see profits from more conventional avenues in banks’ earnings reports.
The problem is that the banks have not always felt that way. The years leading up to the 2007 crash were great ones for giant banks, and that success was built on mergers and acquisitions, the creation of exotic products, and ever riskier trading styles. Those conditions were the model for success as most of the current major leaders in the sector came of age, so recreating them is understandably appealing. It cannot be done, however, without building the solid base of more traditional drivers of profit.
That is why the long-term impact of this week’s bank earnings will go way beyond the headline revenue and EPS numbers. How those numbers were achieved is ultimately much more important than what they are. As long-time bank analyst Dick Bove has been pointing out recently and I said in the article referenced above and elsewhere, trading profits do not matter to long term investors except in as much as they can provide capital for banks to invest elsewhere.
If the big banks reporting this week fail to show a focus on their most fundamental functions, then even spectacular results will only matter in the short term and any rally that follows can be seen as a sell signal.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.