UBS warning signals end of earnings cycle

Today UBS (UBS) announced a 79% increase in 2Q07 earnings, however after stripping out the one off sale of it's stake in private bank Julius Baer and taking a writedown to close the group's hedge fund unit Dillon Read Capital Management, earnings rose a respectable 14%.

However what the market focussed on was the company's forecast for the rest of the year. Management had this to say about 2H07:

"...markets are currently very volatile, and forecasting is even more difficult than usual. If the current turbulent conditions prevail throughout the quarter, UBS will probably see a very weak trading result in the investment bank, offset by predictable earnings from wealth and asset management.

"This makes it likely that profits in the second half of 2007 will be lower than in the second half of last year."

You can get used to this kind of commentary from financials going forward - particularly the big brokers such as Merril Lynch , Goldman Sachs, Bear Stearns etc. The US brokers have already reported strong 2Q07 results however it's going to be much tougher to post even moderate earnings growth in 3Q07 and even tougher in 4Q07.

Why?, the debt market has all but dried up - billions of dollars of corporate bonds have been yanked in the past month and hedge funds are bleeding red ink. This means lower fees for the brokers. Mortgage brokers are already in trouble and banks will also see earnings slide as their cost of financing rises and they cut back on lending.

Marc Faber of arc Faber limited pointed out in a interview on bloomberg a few days ago that financials represent 30% of S&P500 earnings. Also if you add the financial subsidiaries of industrial corporations such as GE capital then the earnings of the financial side of the economy account for around 40% of S&P500 earnings.

On top of that you have homebuilders losing money hand over fist and generally tepid growth from retailers as consumers adjust their spending habits.

Faber says that not only will the earnings of financials not continue to expand but that he thinks they will tumble. If it plays out as Faber expects it will drag the earnings of the entire market into negative territory.

Some analysts have seen the recent sell-off in financials as an opportunity to pick what they see as cheap stocks. However once earnings start to dip into negative territory they will quickly lose their appeal as bargains.

As I noted in a post last month the current US earnings cycle is the 3rd longest since 1950 and after this quarter it will be equal second.

With most S&P500 companies having reported 2Q07 earnings, growth looks to be in the region of 6%. I expect that to more than halve in 3Q07 and if we are not in negative territory by 4Q07 then definitely by 1Q08.