Tomorrow's Forward Look - Earnings Drives The Show

What an odd day in the markets.

Overnight the Nikkei was down fairly strongly, along with the other Asian markets.

Then this morning we got two numbers that the market took as positive - but weren't. CPI, which came in good "ex-food and energy", but of course, as I keep pointing out, who doesn't eat or use gasoline? With food and energy, it was quite hot.

The second was housing starts. And here things got really bizarre. The headline was up.

But - behind that were declines in all regions except the Midwest, which claimed a more than 40% increase. Excuse me? You expect me to believe a forty percent increase in a region where just a couple of weeks ago we had news stories telling us you could buy foreclosures at auction for less than the price of a used car?

But of course you know the deal by now. Bad news is good news, no news is good news, good news is even better news.

So up the market goes. Off the headline - again.

Ok - cool. But now we start to see some discontinuities in the market. Countrywide is up strongly at the open, others flirt around, but there's no longer a strong bid across the sector - now its getting more specialized.... or..... tired.....

Countrywide comes up against the 50DMA and can't penetrate. That was a former technical channel indicator - what's it mean for tomorrow? Let's see what tomorrow brings - but the failure to penetrate the 50DMA is not particularly positive for upward movement from here.

The DOW bounces off the highs and promptly retreats. Technically, that's not so good. The Naz was down a bit, and the S&P up a few. The failure to penetrate resistance in the DOW is not particularly bullish, nor is the lack of strong follow-through in the other two indices.

On top of this the dollar continues to go straight in the ditch. You now need two of them to buy one British Pound. That hasn't happened in a very long time. The index is solidly below 82, down almost a half-point today, and it looks inevitable it will decline below the magic "80" index point. That's bad, by the way. The 10yr bond yield dropped on rate bigtime to 4.69% - from 4.74 yesterday. That's a big move for a day.

Into the close I noted some BIG price deterioration in WM, which was due to report at the close. And report it does.

The headline is that they hit the number, but down 20% YOY from 2006. But then some dead fish start to show up. The instant response of the aftermarket was to pop the stock by a good buck and a quarter - apparently everyone expected a honking big miss. A quick analysis of the numbers shows big downward changes in loss reserves in their credit card portfolio, which was used to offset the (far bigger than it appears on a per-share basis) loss in the mortgage portfolio.

Hmmm.....

So I go at the facts, because something just doesn't look right. And when I do, heh, look at that. Math trumps headlines.

Non-performing loans were up. Way up. 25% increase in one quarter. But they dropped the "doubtful" account number by 0.01? How's that? Oh, and that's against net-chargeoffs which jumped 34% - in three months. Yet the bank's percentage of doubtfuls go down? Equity drops due to a big share buyback (which, by the way, on the conference call they hinted they may continue), and the capital reserves decreased. So let me see if I get this right - equity is down, capital reserves decrease, you vaporize performing loans (booking a GoS) so you can shift reserves and effectively take two credits to the balance sheet (so your mortgage business doesn't look like the huge stinking turd that it was), you take big charges but decrease the percentage of accounts you flag as "doubtful", and then with all that you raise the dividend.

But.... as Monty Hall used to say..... it gets better!

The really big hidden number was the approximately $360 million in capitalized negative amortization in the quarter. That goes to earnings, but as I've noted, its "funny money" - it may get paid, it may not, but really guys..... hitting numbers this way when that segment of the market is known to be a ticking bomb in a declining home value market? And of course that was nowhere in the quick PR releases - you had to go dig for it. Big surprise - NOT.

Take this out and you get about half of the reported value for real earnings - about 40 cents. Ya. Now let's not forget folks - January and February were all "normal" months. So all this damage to the balance sheet was done in one month out of the three! Can you imagine what it would look like if the entire quarter sucked?

The conference call was not full of dummies. They got a few softballs, but also a couple of really good kicks in the nuts. Merrill Lynch was particularly good - their analyst drilled management on the reserve changes, and pointedly asked for the metrics they were using to justify the change. The company refused to give him a straight answer, instead telling him to "focus on the non-card piece"! The last time I heard a company pull that sort of answer out of the hat to a question was during the Internet Bubble. Heh - let the market decide if all this matters. That's how it works - I guess.

In other news YHOO missed expectations bigtime, and got chopped to pieces in the aftermarket. Tomorrow will be interesting for them, and not in a good way. Expect blood in the Internet space. The underperformance, from what I can determine, appears to be company-specific - but I have low confidence the market will take it that way.

Tomorrow morning we have BPOP, CNB and DSL (theoretically on the latter) in the morning, and then ETFC and more after the close. They, along with the market's response to WM's report, will be the "prime movers" tomorrow.

If there's any form of rationality to the market WM has to weigh on trading tomorrow across the board. That sort of hit to earnings off one month, and the one-time accounting shenanigans to dress the pig, would raise all sorts of red flags in any rational market.

But - as has been the case with so much this week, I wouldn't be surprised if we trade higher! Not just WM either - all of the market.

Nonetheless, the cracks are showing up. WM's "lipstick on the pig" was most interesting. The accounting games they played are completely legal - but the bet they made looks to me to be very dubious and extremely likely to blow up in their face next quarter. Among other things they can't pull it again - now the money's gone. They've pulled loss reserves for credit cards they will need if the economy softens or rates rise. They've made comments about the mortgage market implying that they're basically betting on at least a flat (if not up!) - not down - market - yet their major concentration, California, is seeing big year-over-year price decreases in Real Estate.

Cracks in a market tend to start one company at a time. Contrary to popular belief psychology changes that actually stick rarely are initiated by things like the China Surprise in February. Those sort of external events are good for big plunges but they're irrational - and thus, the usual path is a recovery, like we've now seen. Instead, psychological damage to a market as a whole tends to come one company at a time, until people wake up one morning and start wondering if their holdings will be the next to do something like this. That's the "cold sweat" thing that, when it reaches critical mass, causes people to reach for the big red button.

This is the first conference call that I've listened closely to in this sector during this earning's season. I would call a good part of the macro economic look that WM is using for their "forward outlook" somewhere between fanciful and outright magical thinking - oh sure, they can almost certainly grow deposit accounts and credit card holders, and they might even get away with raising fees (their 15% YOY fee increases were eye-poppers - but apparently they got their customers to swallow!) but if they can't earn money off their loans it doesn't really matter.

The $64,000 question is when does the dam break? I don't have an answer to that. But I don't see how WM gets through next quarter's earnings report without a major disappointment in the earnings department, given the housing outlook that we have from all objective sources. If others in this sector are playing with a similar deck of cards and are stacking them in a similar order then that would put the "oh crap" date somewhere in the next three months - certainly before the July earnings releases come out - unless there are some very serious positive changes in the underlying economic facts and housing market.

The error band appears to be getting narrower....

Tomorrow morning's earnings are going to set the tone for the session. I am looking forward to CNB's in particular, as they are over-concentrated in Florida construction loans - I can't imagine those are doing "Sweet Florida Orange" well given the Real Estate market down here. I suspect its more like raspberries.... with thorns.

Oh, as I write this, Mr. Sushi is up about 120 and headed to lunch. There's some color to the Asian markets in general. I'm off to bed early this evening - its going to be a very busy and analytical morning for me with CNB, DSL and BPOP reporting before the bell (among those I care about)

See 'yall in the AM!

Disclosure: I hold WM puts, both short and long term, and also have PUTs on CNB, DSL, BPOP and ETFC. Good trading to you!

PS: I just couldn't resist adding to this. You HAVE TO check out this article over at The Journal regarding Fremont. They "exited" the subprime biz all right - but still have a whole boatload of construction loans on condos in Florida (and elsewhere!) Oh my God! This is the sort of stupidity that the lenders have done themselves in with...... and people wonder why I'd short a BANK? :->