Financial services stocks still look ugly

It is tough to find a stock analyst or money manager with positive things to say about the financial services industry these days. “For the second time this year, we are recommending a "strong sell' on investment banks and the brokerage industry,” Contravisory Investment Management told its institutional clients this month, citing fundamental changes in the historic profit models of firms ranging from giants such as The Goldman Sachs Group Inc. to discount brokers such as TD Ameritrade Holding Corp., commercial-bank behemoths such as Bank of America Corp. and regional brokers such as Stifel Financial Corp. “It's highly unlikely these companies will be able to recognize or adjust to their changed business conditions anytime soon.” Contravisory sells institutional equity research to such brand-name clients as The Bank of New York Mellon Corp. and Fidelity Investments, and also manages about $535 million of assets in stocks for individual investors directly and through separate-account platforms at Envestnet Inc., Mesirow Financial Corp. and other firms. William Noonan, chief executive of Contravisory, said in an interview that uncertainty about the effect of new regulation — including the likelihood of a fiduciary standard for retail brokers — coupled with the end of a near-30-year bull market in interest rates that propelled outsize spreads in lending and trading, led him to renew his bearish call on banks and brokers. The NYSE Arca Securities Broker-Dealer Index, which tracks 11 stocks that include Ameriprise Financial Inc., The Charles Schwab Corp., Goldman, Morgan Stanley Smith Barney LLC and Raymond James Financial Inc., was down 9.9% this year as of last Wednesday, compared with a decline of 1.2% for the S&P 500. During the past 52 weeks, the brokerage index was off 8.7%, compared with a 7.4% gain for the S&P 500. Those valuations aren't enough to attract Mr. Noonan, a chartist who has managed about an 8% return year-to-date by investing primarily in consumer discretionary, technology and cyclical industrial stocks, and has shorted a range of financial stocks. “It would take significant rallies in the stocks to get a technical buy,” he said. Meredith Whitney, a longtime bear on financial services stocks, has also settled more firmly into her negative views as the effects of financial-reform legislation and worldwide calls for more capital to support risky banking businesses become more apparent. “The key product drivers of Wall Street's revenues and profits over the past decade have been in a structural decline over the past three years,” she wrote in a research report from her eponymous firm at the end of last month. “2010 marks the first year in many in which Wall Street-centric firms will go through structural changes.” Goldman and JPMorgan Chase & Co. have said in recent weeks that they will stop proprietary trading of commodities. Goldman and Morgan Stanley are reportedly spinning off some of their hedge fund groups, and they and other banks that once minted profits from securitizing assets are experiencing what Ms. Whitney described as “deeper secular change” in those and other businesses. Big banks and brokers around the world, including Barclays PLC and Credit Suisse Group AG, are particularly vulnerable to continuing retrenchment in fixed income, currencies and commodities trading — activities that fueled much of their profits for more than a decade, she wrote. Ms. Whitney didn't return a call seeking comment. Even banks that focus on fee businesses such as global custody and asset management, rather than more volatile trading and brokerage businesses, face significant roadblocks. Analysts at Goldman on Aug. 30 lowered their earnings estimates and price targets for their universe of trust banks — Bank of New York, Northern Trust and State Street Corp. — by 8% in 2011 and 6% in 2012, citing lackluster equity flows from clients and persistently rock-bottom interest rates that for the foreseeable future are devastating net-interest margin, and stock-lending spreads and revenue. The trust bank stocks are trading at about 11 times expected earnings, compared with a 10-year average multiple of about 17, but Goldman isn't biting. “While these valuation levels offer a good long-term-value entry point, our "lower-for-longer' rate view, coupled with an uncertain market environment, will likely keep fundamentals under pressure in the near term,” the analysts wrote in a report. They have a “neutral” rating on the group and a “buy” only on Northern Trust. Contravisory, which looks for 18 to 24 months of stable direction in industry groups before buying into a sector, expects the negatives to persist. “Investors net-net have been reducing exposure, leading to significant selling pressure,” Mr. Noonan said. “They wanted to believe that the group would recover after [the Troubled Asset Relief Program] and the bailouts — and it did for about six months — but after the initial euphoria, we began to see the selling pressure again.” The pall also may be stalling the debut of some initial public offerings, including that of LPL Financial, according to some observers. The independent-brokerage giant in June registered plans to sell up to $600 million of stock held by its private-equity backers, executives and some of its more than 16,000 independent brokers.

"HOSTILE ENVIRONMENT'

“It's a hostile environment for financial services to launch,” Mr. Noonan said. Thomas Ruggie, whose Ruggie Wealth Management uses LPL's hybrid platform as a custodian for client assets and which plans to sell shares into the IPO, said that he hasn't been given any signals on timing. “My personal opinion is that if markers were favorable, they would have already done it,” he said. “There's some concern about coming out with an IPO in this market.” Representatives of LPL didn't return calls seeking comment. This story was supplemented with reporting from Bloomberg News. E-mail Jed Horowitz at jhorowitz@investmentnews.com.