JPMorgan Just Booked the Biggest Bank Profit in History While Chip Stocks Fell Apart

A Record That Is Hard to Overstate

On July 14 JPMorgan Chase reported second-quarter net income of $21.2 billion

Sit with that for a second. This is not a bank that takes a dime to make the stock explode for a morning. It is the largest bank in the country and it is having its best three months ever by a wide margin in an industry that is supposed to be mature heavily regulated and structurally incapable of growing like a technology company

When a company releases a figure like that the useful question for an analyst is not like but why nowWhat changed in the economy to allow a mature heavily regulated institution to increase its profits by two-fifths in a single year? Banks don't invent a new product line in twelve months. Something in the environment around them shifted

Goldman's Best Quarter Ever

JPMorgan was not alone. Goldman Sachs reported diluted earnings per share of $20.98 nearly double the same quarter a year earlier on net income of $20.34 billion an increase of 39 percent. It was the best quarter in the firm's history

Across the group about 88 percent of the companies that had reported beat earnings expectations and about 85 percent beat revenue expectations. That matters more than any of the headlines. A bank that has a monster quarter may be a trading desk that gets lucky in a single position. Nearly nine out of ten journalists hit is another piece of evidence. This was a broad hit not a lucky name

What Is Actually Driving the Numbers

Two engines did most of the work. The first is trade the business of buying and selling securities for clients and for the bank itself which thrives when markets move a lot. Volatile rates and choppy stocks gave the desks plenty to do. Trading income is approaching a direct tax on uncertainty. The more clients need to reposition themselves the more times a bank sits in the middle and accepts a spread

The second is investment banking the fees banks earn advising on mergers and helping companies raise money. That business had been in a multi-year drought while high rates froze business activity and it's finally reviving. Transaction fees are uneven and slow which is why a recovery there says more about next year than it did about the last quarter. No one signs a merger deal for a good week. They sign because financing is available and boards of directors have stopped batting an eye

Beneath both lurks a healthier-than-expected consumer. Credit conditions held up spending remained resilient and default rates did not rise as pessimists feared. A bank's results are a reading of the entire economy because banks lend to the entire economy. The record profits here are a vote of confidence that the soft landing is real

There is one subtlety worth noting. The two engines are not independent. Trading loves volatility and deals hate it. Getting record contributions from both in the same three months is unusual and is the type of alignment that tends not to repeat itself

Meanwhile, the Chips Cracked

You would expect the huge bank profits to lift the entire market. They didn't. The Nasdaq Composite the technology index fell 2.9 percent for the week while the S&P 500 lost 1.55 percent and the Dow fell 0.93 percent

The brakes came from semiconductors. Chip stocks posted their third weekly decline in four weeks with a widely followed semiconductor fund falling nearly 9 percent during that period worsened by volatility in the South Korean market where several major chipmakers are listed

So that same week we had the best banking quarter in history and one of the worst stretches for chips this year. Both facts are true and the tension between them is the real story

The Rotation Underneath the Averages

What seems like a bad week was actually a rotation investors sell one group to buy another rather than fleeing stocks altogether. Money flowed out of expensive technology and into financials real estate consumer staples and healthcare the areas that held on as chips fell

The reason is valuation. The S&P 500 was trading at a forward price-earnings ratio of 20.3 meaning investors paid $20.3 for every dollar of expected earnings above its 5-year average of 19.9 and its 10-year average of 19.0. When an index is priced perfectly big gains in cheap sectors are rewarded and any swings in expensive sectors arepunished

A Worked Example: What 20.3 Times Earnings Actually Costs You

The phrase "price of perfection" is used without anyone doing the arithmetic. It's worth doing because the arithmetic is simple and makes up the entire argument

Start by turning the multiple upside down. A P/E ratio of 20.3 is the same statement as a earnings performance of 1 divided by 20.3 which is 4.93 percent. That is the portion of the company's profits that is purchased for each dollar committed before it grows

Now put it next to the risk-free alternative. The 10-year Treasury bond has been trading around 4.5 percent. Subtracted the reward for owning the entire U.S. stock market instead of a government bond is about 0.4 percentage points. Call it forty basis points of compensation for accepting recessions credit cycles competitive disruptions and the occasional 30 percent drawdown

Perform the same calculation with the 10-year average multiple of 19.0. The earnings yield becomes 5.26 percent and the cushion on the same bond widens to about 0.76 points. That's still tight by historical standards and almost double what's being offered today

Then ask what has to happen for the index to simply grow back to its own history. To go from 20.3 times to 19.0 times without the price falling earnings have to increase by 20.3 divided by 19.0 which is 1.068 or 6.8 percent. That's the bill. Earnings growth of about seven percent means nothing in terms of price. It simply returns the market to its normal valuation

These are illustrative numbers rounded for clarity and bond yields vary daily. The point survives rounding. At 20.3 times a good year of earnings growth has already been spent before it arrives and the yield you actually get depends on the multiple staying where it is. That's what a market valued for perfection means in numbers rather than adjectives

Case Study: Cisco and the Difference Between a Great Company and a Great Stock

If you want to see what happens when earnings are great and the multiple is not the clearest case in modern US markets is Cisco Systems

In March 2000 Cisco briefly became the most valuable public company in the world. It was not a fraud and it was not a story. It sold the routers and switches that physically carried Internet traffic dominated its market and was truly one of the best companies of its generation. At its peak it traded at more than 100 times forward earnings

Here's the part people forget. Cisco's business continued to run. Revenue over the next two decades multiplied several times over. It remained profitable continued to dominate core networks generated a huge amount of cash and paid out billions to shareholders. If you had been given a sealed envelope in March 2000 containing Cisco's actual revenues and profits for the next twenty years you would have aggressively bought the stock

You would have lost. The stock fell about 80 percent in the crisis that followed and never regained its March 2000 high. Investors who bought at the top were right about the company and wrong about the price and being right about the company didn't save them. The entire loss was due to the multiple squeeze not the failure of the deal

That's the mechanism now being shown in reverse. Banks are generating record profits from multiples that were never demanding so profits translate into yields. Semiconductors are generating strong profits from multiples that are already years old so weak data costs real money. Same market same week opposite results and the difference is entirely what was already in the price

Where the Rotation Story Breaks

I want to argue here against my own approach because the rotation explanation is seductive and only sometimes correct

The first problem is that a week is noise. Rotation is a narrative we apply after the fact to a set of price movements that may simply be a sell-off of crowded trades a de-risking of a single large fund or an index rebalancing. The honest test is whether the flow persists for a quarter. Anyone declaring a regime change in five trading days is selling a story

The second problem is more serious and hurts banks. Record bank profits are a lagging unanticipated signal. Credit losses come late in a cycle long after the loans that caused them appeared profitable. In 2006 and early 2007 American banks posted excellent results traded at undemanding multiples and were widely described as the cheap safe corner of the market. They were not. Buying financial stocks because they are cheap in the face of a spike in qualityCredit is one of the oldest value traps in existence and the fact that this quarter was a record is exactly the condition under which that trap is most attractive

The third problem is that the decline in chips might not have anything to do with valuation at all. If the weakness in semiconductors reflects a genuine deterioration in orders inventory or capital spending plans then it is an early warning about the capital investment cycle and the correct reading is not "expensive stocks got cheaper" but "the economy's strongest demand driver is cooling." Those two readings look identical for several weeks and then diverge violently

My honest position is that I still can't distinguish between them and I'd rather say so than choose the clearest explanation

How I Actually Read an Earnings Week

When a week like this comes around I try not to react to the index number at all. It's an average of things moving in opposite directions so it tells me almost nothing

Instead what I do is quite mechanical. I write the pace rate first because it separates a market that moves on fundamentals from a market that moves on positioning. When 88 percent of the journalists beat and the index continues to fall I know that the movement was not about results. It was about what results were already assumed

I then divide the moving companies into those that became cheaper and those that became more expensive and ask them which group I would have to be wrong to lose money. That framing has been more useful to me than trying to forecast the direction. Owning a bank at a modest multiple means being wrong about the credit costs that can be lost. Owning a chip name on a rich one means being wrong about the multiple which is much harder to back up because it depends on the state.of other people's mood

My read on this particular week is that the strength is real and the price is high and that combination usually resolves over time rather than through a decline. Earnings rise in valuation the market moves sideways for a while and everyone considers it boring. That's my base case and I keep it loose because the same setup occasionally resolves more quickly

None of this is investment advice and I want to be direct about it. I am a student who writes down how he reasons without telling anyone what to buy

Two Signals, One Market

If the pieces come together the market will send two messages at once. The economy is strong enough to give banks a record quarter and rich enough in valuation that investors will become choosy about what they pay

That's not a contradiction. This is what a late fully priced market looks like with strong fundamentals meeting cautious buyers

The Bottom Line

JPMorgan's record $21.2 billion quarter and Goldman's best-ever results confirm that both the real economy and capital markets are working. Indices fell however as a decline in semiconductors and overblown valuations caused investors to abandon expensive technology toward cheaper more stable sectors

Arithmetic explains the mood better than the headlines. At 20.3 times forward earnings you get an earnings yield of 4.93 percent versus a bond paying about 4.5 percent and the index needs earnings growth of nearly 7 percent just to return to its 10-year normal. In that setup the good news is the entry fee not the reward

The takeaway for a student looking at this is that in a market valued at 20 times earnings winners are decided less by whether the earnings are good and more by whether they were already discounted.Cisco was a wonderful company in March 2000 and a catastrophic stock on the same day. Keep the two questions separate and be honest about the fact that record bank profits look best just before the credit cycle reminds everyone why the multiple was low