Next week is the highly awaited FOMC meeting and the expected decision next Tuesday is certainly that a rate cut is coming.  But the predicament bet is mixed, with some looking for a 25-basis point cut and others expecting a 50-basis point cut.  Before we digress into what the FOMC should or shouldn’t do, keep in mind that the brokerage firm giants will all start reporting earnings next week.  That alone may actually show just how damaged the lending and financial fallout is on their bottom line, or it may show that the recent recovery was justified.

Frankly, the bond market has almost always been smarter than equities as a predictor of rates and the economy.  The Federal Reserve is so far behind the yield curve that you have to wonder either how smart the bond traders are or how incredibly dense the academia crew running monetary policy really is.  The two-year treasury note, one of the current benchmarks, is almost 125 basis points shy of the 5.25% Fed Funds rate.  That’s all fine and dandy, but what is going to run the financial sector perhaps even more than the FOMC (mandatory, at this point) cut is the earnings wave coming from bulge bracket Wall Street investment banking giants.

Please be advised that earnings estimates have come in sharply in most cases over the recent weeks because of the mortgage and lending derivative malaise that the markets have weathered.  It is also quite possible that these estimates will come in farther as analysts still have three mornings to make their changes to estimates.  If you saw how well these stocks performed on Thursday, you might not think anything had ever gone wrong.  Obviously that isn’t the case.  Some of these estimates could have also changed from calls on a given day, and most analysts have been trimming the estimates.  Here is the expected report schedule with current estimates:

Lehman Brothers (NYSE:LEH) reports on Tuesday (9/18) and estimates are $1.47 EPS & Revenues of $4.3 Billion.  Estimates were a dime higher just last week and were $1.81 EPS 60 to 90 days ago.

Morgan Stanley (NYSE:MS) reports on Wednesday.  Morgan Stanley is expected to post $1.53 EPS & $8.3 Billion in revenues.  Estimates were $1.60 last week and were over $1.82 90-days ago.

On Thursday (9/20) we get the dual reports from Bear Stearns (NYSE:BSC) and from Goldman Sachs (NYSE:GS).  Bear Stearns (NYSE:BSC) is expected to post $1.78 EPS on $1.65 Billion in revenues.  Just a week ago, estimates were over $2.00, and were over $3.00 60 to 90 days ago.  Goldman Sachs (NYSE:GS) is expected to post $4.35 EPS & $9.55 Billion in revenues.  Goldman Sachs has seen the least amount of estimate changes of the bulge bracket firms.

Thursday was a huge day for these brokerage giants, so maybe the worst is behind after all.  Billionaire investor Joe Lewis just invested close to $1 Billion for a stake in Bear Stearns and he now appears to be the single largest shareholder.  PIMCO has reportedly set up a $2 Billion distressed mortgage fund.  A recent vulture fund was registered for an IPO to buy distressed debt.  A huge infusion in debt and mortgage buying came from above.  Oh yeah, and that yield curve is signaling that the FOMC is about 3 or four months behind the curve. 

The main thing to watch here is how all of the crummy mortgage and lending operations and all the derivatives and losses tied to these are impacting the brokers’ bottom lines.  Oddly enough, the expectation is for all of these to still be profitable on a net basis.  Some may mask actual losses with an asterisk by saying there are one-time events since many operations are being cut, geared down, or eliminated.  We’ll also get to see if more layoffs or entire unit closures in these areas are coming.  Regardless of the FOMC and regardless of the "Big Picture" you know the malaise in that sector hasn’t ended for all the workers in that group.

But, back to earnings.  For longer than recent memory can serve, the old formula was that brokers would handily beat earnings estimates and see shares fall off in profit taking.  The last earnings report out of the sector wasn’t exactly a blue ribbon, and that may become more of the norm.  It would seem as though now the only issue is just how weak the street is willing to settle for on the current earnings.  Just at the start of August, Bear Stearns was looking like it might even crack under the $100 mark more than just that one intraday trade.  The merger wave isn’t going to be there for the coming quarters that was the norm over the last eighteen months, and even the IPO calendar has been soft at best.  The very recent economic numbers aren’t showing great overall trends for the sector’s customer base.

Most of the bad news should be known.  Now we just have to wait to see how many skeletons are in the closet.  If that is true, it should boil down to what investors are willing to live with.  Even after today’s large rise in the brokerage firm stock prices these are all way off of recent 52-week highs:

Broker                    Stock         52WK-High
Lehman Bros.      $59.68          $86.18
Morgan Stanley    $66.79          $90.95
Bear Stearns        $114.83        $172.61
Goldman Sachs   $188.47       $233.97

A.G.Edwards (NYSE:AGE) also reports Thursday (9/20) and estimates are $1.12, but this one is being acquired and rolled up by Wachovia (NYSE:WB) and its vote to approve the deal is at the end of the month.

Lastly, these reports may have some serious impact on many of the money center banking giants because they have so much overlap in the exposure and business units.  These would be the likes of Bank of America (NYSE:BAC), Citigroup (NYSE:C), J.P.Morgan (NYSE:JPM), Wachovia (NYSE:WB), and Wells Fargo (NYSE:WFC).

Jon C. Ogg
September 14, 2007

Jon Ogg can be reached at [email protected]; he produces the 24/7 Wall St. Special Situation Investing Newsletter and he does not own securities in the companies he covers.

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