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Markets & Stocks

Beaten-down brokerages
Four big brokerage houses report 3Q earnings next week, but investors will be looking to the future.
September 16, 2004: 1:42 PM EDT
By Mark Gongloff, CNN/Money senior writer

NEW YORK (CNN/Money) - When several big brokerage houses report third-quarter earnings next week, much of what they'll say will be old news. It's no secret that selling stocks during this summer's long, meandering malaise was about as much fun as peddling Bibles on the Vegas strip.

"These brokerages are going to say about the quarter that just ended, 'It never happened,' because basically all of the core businesses you look at were flat or down somewhat," said Richard Bove, brokerage analyst with Hoefer & Arnett. "Depending on the company and the nature of its earnings base, earnings will be weak to very weak."

Investors will pay closer attention to what Goldman Sachs, Morgan Stanley, Lehman Brothers and Bear Stearns will say about the future. Problem is, that may not look so bright, either, if the economy, corporate earnings and equity markets aren't in for better days ahead.

Goldman Sachs (GS: Research, Estimates), which reports Tuesday morning, and Morgan Stanley (MWD: Research, Estimates), which steps up on Wednesday morning, are expected to post higher profits. That's thanks partly to brisk business in their energy trading units, spurred by skyrocketing oil prices.

But both banks also have the highest exposure to total trading activity of the group, so there's a chance they'll also have the worst earnings.

After all, the fiscal quarter, which ended on Aug. 31, was dismal for these and other brokers, with anemic volume and falling stocks. The Nasdaq lost a whopping 7.5 percent in the quarter, the S&P 500 fell 1.4 percent, and the Dow Jones industrial average was nearly flat.

Meanwhile, aside from the headline-grabbing Google (GOOG: Research, Estimates) initial public offering, IPO and other investment banking activity has been similarly dead in the water.

Goldman earnings are expected to rise to $1.48 a share from $1.32 a year ago, according to consensus forecasts tallied by earnings tracker Thomson Financial. Morgan Stanley is expected to post a 97-cent-per-share profit, compared with 83 cents a year ago.

Lehman Brothers (LEH: Research, Estimates), which reports earnings Monday before the opening bell, and Bear Stearns (BSC: Research, Estimates), which reports Wednesday morning, are expected to post third-quarter profits down sharply from a year ago.

Wall Street analysts, on average, think Lehman's earnings fell to $1.55 a share, compared with $1.81 a year ago. Bear Stearns is expected to report a profit of $1.99 a share, compared with $2.30 a year ago.

Bear Stearns, which has broader exposure to the bond market than its competitors, could benefit from a surprisingly robust market in the quarter. Though prices for very short-term Treasury notes fell, demand for longer-dated bonds was healthy, thanks in part to concerns about a weakening economy.

They'll walk the line

Though nobody's numbers are expected to set the world on fire, the stocks probably won't suffer, as long as none of the banks miss estimates, said Jeffery Harte, analyst with Sandler O'Neill & Partners in Chicago. Where things will start to get dicey is when the banks start laying out the Tarot cards for the fourth quarter and beyond.

"It will be a bit of a challenge for management, in that they probably don't want to sound too optimistic; it's generally in their best interest to keep expectations moderate," Harte said. "At the same time, they don't want to sound too bearish on 2005."

For better or worse, the outlook for the brokers is tied to the outlook for the economy, corporate earnings and financial markets. Most economists believe activity will decelerate next year, as will earnings growth, but the economy will settle into a comfortable, steady hum, not growing like gangbusters, but not falling off the table, either. Stocks could conceivably do just fine in such an environment.

But Wall Street has been worried all summer about the prospect that things could be worse than that -- and those fears haven't gone away. High oil prices have often been blamed for the economy's "soft patch" in the second quarter, when growth fell below average. Oil prices are still fairly high, and there are signs that the economy is still struggling.

After four straight quarters of 20-percent-plus annualized gains, corporate earnings growth would almost certainly slow down, even in a fairly robust economy. And if the economy's not falling off the table, then the Fed will likely keep pushing interest rates higher, finally hurting the bond and mortgage lending market, which would hurt Bear Stearns.

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There could still be winners in such an environment. Bove of Hoefer & Arnett believes Goldman Sachs and Morgan Stanley have strong-enough trading platforms to survive and will benefit from commodities demand and their leap into Asian markets.

"They're positioned better than Bear Stearns, Lehman or Merrill Lynch (MER: Research, Estimates)," Bove said, "so those are the two bets I'm making."

"Of course, those are also the two that are going to have the lousiest third quarters," he added.  Top of page

None of the analysts quoted own shares of the stocks discussed. However, Sandler O'Neill does have or seeks a banking relationship with them all.

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