Brokers' Profits Riskier

This blog post originally appeared on RealMoney Silver on Aug. 14 at 8:17 a.m. EDT.

The longs view the brokerage stocks, at roughly nine times earnings and trading at historically modest premiums to book value, as statistically cheap. As I mentioned in Barron's, I disagree with that even more firmly than when I wrote cautionary remarks back in June.

Though the shares are oversold for the short term, both cyclical and secular forces are conspiring to put the brokerage industry's profits in jeopardy. A moderation or contraction in credit products, private equity and hedge fund industry growth, when combined with mark-to-market and prime brokerage liabilities, suggest that the risks of ownership of brokerage stocks outweigh the rewards.

As a result of these conditions, earnings expectations remain far too bold, and company profit warnings are expected to begin posthaste. Last night, UBS (UBS Quote) warned (over there) that second-half profits will disappoint, and its shares have dropped by nearly 4%.

Bubble Buddies

The brokerage industry's fortunes are joined at the hip with the bubbles in credit (and derivatives) expansion and private equity, two correlated and intertwined asset classes. Unfortunately, these two bubbles have recently been pierced, marking a clear first-half 2007 peak in industry profitability. (This peak will not likely be reversed for at least another two years.)

Over the last decade, brokerages have feasted at the trough of credit availability. However, the current credit crunch, leading to a temporary cessation of private-equity deals, is clearly changing that tailwind into a headwind. Brokerages' returns on investments have been goosed by the rapid growth in all types of fixed-income (and derivative) products, and the cycle's reversal spells lower securitization packaging fees and lower secondary credit market trading volume of the many credit and derivative products.

Moreover, the $8 billion-plus in first-half advisory fees -- principally M&A, which is importantly influenced by private equity deals -- will decline dramatically in 2007's second half and seems destined to moderate further into 2008.