Felix Salmon

When it comes to earnings, Wall Street wants guidance. Here’s the cri de coeur from Societe Generale’s Bill Kavaler Cavalier, during the notorious conference call with Sallie Mae’s Al Lord yesterday:

We’re trying to put together projections here, Al. We’re trying to figure out what your stock is going to be worth, and you have got to give us some guidance, you’ve got to give us some numbers… Can you give us some handle on what your stock is worth?

Lord, of course, told Cavalier to go elsewhere for his guidance; investors voted with their feet, and bid the stock down more than 20%. Most companies deal with such questions with a bit more panache, and their earnings generally arrive more or less in line with the expectations they themselves are largely responsible for creating. Investment banks have a harder time of it – their earnings are necessarily more volatile than those of the average widget manufacturer. And when they take losses, it seems that guidance and expectations are utterly useless.

Yesterday, Morgan Stanley’s quarterly loss was 926% of the expected size; today, Bear Stearns’s quarterly loss of $854 million is 380% of the amount that Wall Street analysts expected.

Remember, Wall Street knew there would be losses. It’s not like no one told them there was a massive cock-up on the Morgan Stanley trading desk. As long ago as early November, Morgan Stanley was making noises about “negative convexity” and saying that its trade-gone-wrong had cost $3.7 billion. It’s just that $3.7 billion looks positively elfin compared to the losses which were finally realized yesterday.

And yet the stock went up, of course. It’s a bit weird, but when a firm’s profits miss expectations by a fairly narrow margin, the effect on the stock price can be large. When a firm’s losses miss expectations by an enormous margin, by contrast, Wall Street is more likely to shrug than panic. For some reason, it seems, the minute that earnings fall below $0, they no longer seem to be treated as a highly-calibrated indicator of a company’s value.

Tinbox, in the comments to my last Morgan Stanley post, makes a very good point: that China Investment Corp must have been given lots of material non-public information in advance of Morgan Stanley’s Q4 earnings announcement.

I don’t know how long it takes the Chinese to do due diligence on a bank the size of Morgan Stanley, but if it’s more than four trading days, we have a prima facie problem here. That’s because under SEC regulations, such information must be released on a “rapid and current basis,” which the courts take to mean four days.

Of course it is conceivable that this deal got done in the space of four days. Keith Bradsher says that it’s “an abrupt shift in strategy for the $200 billion fund,” whose chairman said as recently as November 29 that he “would mainly invest in financial instruments like index products”. Bradsher also describes the decision to invest as “sudden”. But given the complexities of Morgan Stanley’s balance sheet – Paul Murphy notes today that its “unallocated economic capital was a negative $4.1 billion” at the end of the latest quarter – it would surely take either enormous guts or an incredible amount of financial sophistication to make a $5 billion investment decision essentially over the course of a long weekend, especially when that decision involved buying in very close to a market price which did not reflect the write-down news.

But given the timing of Zoe Cruz’s defenestration at the end of November, one has to suspect that Morgan Stanley has been sitting on the news of these losses for much more than four days – and that CIC has, as well.

Incidentally, since I’ve ventured far into the land of rampant speculation already, here’s another thought: could the Morgan Stanley bid this morning be coming from the same people who have been buying in to the Chinese stock-market bubble? Given that the Chinese government now owns 10% of Morgan Stanley, some investors might assume that the bank has an inside track in that country – something which could prove to be very valuable indeed, over the long term.

Update: Just to be clear, here, I’m not accusing CIC of doing anything wrong at all. I’m worried about what Morgan Stanley did. If Morgan Stanley had material non-public information about its losses and didn’t divulge it to shareholders in a timely manner, that would violate SEC regulations.

I puzzled yesterday over the question of why Goldman Sachs fell in the wake of spectacular earnings. Today, it’s the other way around: how on earth is Morgan Stanley’s stock rising in the wake of losing $3.56 billion last quarter?

The stock-market reports aren’t a huge amount of help. Investors were “pleased to hear that the company got a $5 billion infusion from China’s government-controlled investment vehicle, China Investment Corp,” says Madlen Read of the AP. But by my calculations CIC is buying in at a discount of about $2 a share to where MS is trading right now: the stock is hardly trading up to the latest valuation point.

My feeling is that if anybody tells you that they understand today’s price action in Morgan Stanley, they’re lying. The only thing I can think of is that there was some kind of insider trading going on: a lot of people knew or suspected that the bank would take an enormous loss this quarter, and went massively short ahead of the earnings announcement. But I don’t really believe that: what I do believe is that short-term stock movements are, to all intents and purposes, random – even on the day of an earnings announcement, when there really is new news to move the market.

Morgan Stanley’s Q3 earnings were bad. "Mack

Smacked" was the Portfolio headline, reacting to a lower profit (just

$1.54 billion, John Mack’s first quarterly earnings decline) and a nasty $940

million write-down on bad loans.

Ah, those were the days. Just look at the Q4

results: an eye-popping $3.56 billion loss, and an even more enormous

$9.4 billion write-down on bad mortgages. Many on Wall Street suspected Morgan

Stanley’s earnings might be bad, but this is literally an order of magnitude

worse than expectations:

The loss of $3.61 a share in the three months ended Nov. 30 compares with

net income of $1.98 billion, or $1.87 a year earlier. Analysts were estimating

a loss of 39 cents, according to a survey by Bloomberg.

I have to say I’m quite flabbergasted at the size of the write-down. Morgan

Stanley’s meant to be an investment bank, ferchrissakes, not a lender

or a bond investor. It has no business holding that sort of quantity of mortgage-backed

bonds on its books. And indeed its pure investment-banking business seems to

be doing rather well:

Morgan Stanley ranks second after Goldman among the world’s biggest advisers

on mergers and acquisitions announced in 2007, data compiled by Bloomberg

show. The firm advised on $42.2 billion of takeovers completed during the

fiscal fourth quarter, more than double a year earlier.

In equity underwriting, Morgan Stanley managed $14.1 billion of offerings

during the quarter, up from $13.6 billion a year earlier, Bloomberg data show.

John Mack, like Jimmy Cayne, is foregoing his bonus for the year, which is

quite right too. He didn’t leak

the news to the WSJ in advance, maybe because he didn’t see the point in

drawing attention to it. Both Mack and Cayne must now be considered on deathwatch

– the Morgan Stanley buck stops with Mack, remember, not with the ousted

Zoe Cruz.

Oh, and did I mention? Morgan Stanley is also selling 10% of itself to China

Investment Corp. A lean and mean investment bank, like Morgan Stanley considers

itself, clearly can’t weather a $9 billion write-down without raising new capital

to cover it, so it’s good that these two announcements were made simultaneously.

That said, however, I wouldn’t be at all surprised to hear that Carol Loomis

was now looking into Morgan Stanley in much the same manner in which she investigated

Citigroup last month. Morgan Stanley would seem to have had a pretty clear

notion of the magnitude of these losses back in November, when it fired Cruz.

If that’s true, Morgan Stanley was sitting on this material information for

a good three weeks. Which would not look good.

"We’re cautious about the near-term outlook for our businesses as

we see dislocation in some of the world’s capital markets has continued."

–Goldman

Sachs CFO David Viniar, in a conference call with reporters.

Now, I do appreciate that Viniar was talking to reporters, so what

he had to say must have been very important. But really. Is there a

single stock-market investor anywhere in the world who’s unaware of continued

dislocation in global capital markets? (Hint: the ECB just poured half

a trillion dollars of liquidity into the European financial system. Does

that sound normal to you?)

The fact is that Viniar, like any CFO worth his salt, is a naturally cautious

chap. He’s naturally cautious on every single earnings call he’s ever on.

If there are two things which are absolutely known to investors in GS, it’s

that (a) there’s continued dislocation in global capital markets, and (b) David

Viniar is a cautious chap.

Meanwhile, on the same conference call, Viniar announced that Goldman had made

a record amount of money in its lastest quarter, and also announced that he

was allocating $12.5 billion towards buying back Goldman Sachs stock, even at

its present levels of more than $200 per share.

But here’s the thing: Goldman shares actually fell more than $7 today, even

as the broader market rose. Some reporters simply did their job, and reported

this fact, sometimes using words like "despite"

or "even

though" to make it clear that Goldman’s earnings really

were very good. But it was inevitable that someone was going to write a

lede like this:

Goldman Sachs Group Inc said on Tuesday fourth-quarter earnings rose 2 percent,

beating expectations and capping a record year, but its shares fell after

the investment bank cautioned that markets will remain challenging in the

near future.

Was that really why Goldman shares fell? I very much doubt it. There are other

reasons why Goldman stock might have fallen today, if you’re a believer in stock-market

causality – the Value-at-Risk numbers, especially, seemed to imply that

Goldman’s risk-adjusted profits might actually have fallen, and that any increase

in profit was essentially paid for by taking on a lot of extra risk.

But the fact is that any given stock, on any given day, even if that day sees

the release of an earnings report, moves in an essentially random direction.

If you want to see what’s happened to Goldman Sachs shares, don’t look at where

they closed today compared to where they closed yesterday: look at where they

are now compared to a month, or a quarter, or a year ago.

After all, most of the news in the Goldman Sachs earnings report was largely

expected, and therefore "priced in": it’s not like the fact that Goldman

made lots of money by selling its interest in a bunch of power plants, for instance,

came as any surprise to the markets. So if you want to see how the market has

reacted to the past quarter’s news, look at how the share price has moved over

the past three months; don’t look at how the share price has moved over the

past day.

Now, it would be great for my argument if Goldman shares had actually risen

substantially over the past three months; in fact, they haven’t. They rose to

over $240 at the end of October, but they’ve been falling back since then, and

now they’re pretty much back to where they were in mid-September. Still, if

you’re looking for a decline, that’s the decline you should be explaining. And

if you want to associate that decline with continued dislocation in

global capital markets, go right ahead. It’s just silly to pretend that the

dislocation came as any surprise to Goldman’s shareholders.