($GS) Why Financial Earnings Leaders Means Bad Times Ahead

July 29th, 2009

Ryan Cole, The Investment U Research Team

The financial sector has led the market rally the last few days – and, as a student of history, that should give you pause.

We’ll get into that in a moment, but first… why are financials making such a solid run?

Short answer: Surprisingly good earnings. So good, in fact, that Goldman Sachs (NYSE: GS) just set a record for their best quarter ever – so good that they can afford to set aside over $11 billion for compensation alone.

Both Citigroup (NYSE: C) and Bank of America (NYSE: BAC) also beat estimates, pulling in billions last quarter, less than a year after getting bailed out with TARP funds.

But don’t let that fool you. Goldman Sachs, for one, has already paid back their TARP loan, with interest – over 22% annualized interest, in fact. The government made loan-shark money on at least this corner of the TARP bailout.

So, when we see Bank of America shares gain almost 10% in a week, why aren’t we thrilled? When Morgan Stanley posts a 5% gain over the same time, shouldn’t we be ecstatic?

No.

Four Warning Signs for Bank Earnings

There’re a few reasons for skepticism…

First, the earnings are largely illusory. Bank of America comes right out and says it – there were a number of one-off profits in the numbers, and the second half of the year should be much more difficult.

Second, the earnings aren’t signs of true recovery. They aren’t based on solid economic recoveries… but rather on yet more speculation, and the fees therein.

In other words, the banks are getting a nice cut of money that’s being moved around… but nothing of value is being produced. And little of value is being sold – these banks still aren’t making loans to most homebuyers or small businesses.

Third, with so much of the competition now bankrupt and out of business, these companies should be doing even better. Think about it – Bear Stearns, Lehman, CIT, countless others are all gone. The banks left standing ought to be doing much better, as more business comes their way.

But the real reason this ‘recovery’ has us worried? Simply put, the sector that led you into a bear market is never the one that leads you out. As long as financials are leading the way, you should be extremely wary of this latest rally.

The Charts Agree

The technical indicators support this. On July 14 – right around the time financials took the lead in the current rally – the S&P 500 crossed above both its 20-day and 50-day moving average, into overbought territory.

It’s stayed there ever since, with some of its most overbought days coming in the past week. Meanwhile, volume has been declining ever since March kicked off this latest rally.

So, what’s all this mean? Basically, sometime soon, we’re due for a fall. We could be seeing the start of that this week.

Just Because The Markets Fall, Doesn’t Mean You Have To

I would consider buying some October puts on some of the financials – especially Bank of America (NYSE: BAC), which has had the biggest run-up, on some of the weaker numbers.

I’d also take a small position in the ProShares Ultrashort S&P 500 (NYSE: SDS) in anticipation of this fall.

To be clear, it’s impossible to know exactly when things will turn down (or up, for that matter).

It’s also impossible to know how low (or high) any trend will run.

The one thing we can know, though, is this rally is near its top, and losing steam fast. Getting in position to make some money as the market falls just makes good sense.

Good investing,

Ryan Cole

View original at: Investment Advice and Investment Research with a Contrarian Point of View

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