Wall Street Is Priced to Move

There's no doubt some ordinary investors are rejoicing in the drubbing the big brokerage and bank stocks have endured this year.

Indeed, given the pounding investors have taken to their own portfolios, it's only fitting that the Wall Street firms that aggressively peddled the stocks and bonds of wayward companies like Enron, WorldCom and Global Crossing get their comeuppance. It's like a lung cancer sufferer finding solace in a jury issuing a big money judgment against a tobacco company.

But rejoice as you may, there's also no doubt that some financial stocks are awfully cheap on a valuation basis. In particular, look at shares of Merrill Lynch(MER Quote - Cramer on MER - Stock Picks), Citigroup(C Quote - Cramer on C - Stock Picks) and J.P. Morgan Chase(JPM Quote - Cramer on JPM - Stock Picks) -- the three financial institutions that have been the subject of more ugly headlines and investigations than any other bank or brokerage.

Out of Favor

Shares of Merrill, Citigroup and J.P. Morgan all are trading at historically low price/earnings ratios. Based on actual earnings for the first-half of the year and Thomson Financial/First Call consensus estimates for the remainder of 2002, shares of Merrill are changing hands at 12 times earnings, while Citigroup and J.P. Morgan each trade at a multiple that's roughly 10 times earnings.

By comparison, shares of Goldman Sachs(GS Quote - Cramer on GS - Stock Picks) are trading at 17 times full-year 2002 earnings -- pretty much what you'd expect for a major investment bank or financial institution. Back at the height of the bull market in early 2000, most brokerage stocks traded at an average P/E of 18, according to First Call.

Now, it's true the valuations for Merrill and J.P. Morgan aren't too appealing, when you look at the P/E ratios for these stocks based on actual earnings for the past 12 months. Using that analysis, First Call reports that Merrill shares trade at an eye-popping P/E of 133 and J.P. Morgan's stock trades at 33 times earnings. Only Citigroup trades at a still lowly P/E of 11, the kind of a multiple you'd expect to find with a neighborhood thrift.

Don't Look Back

But it's important to remember that the past 12 months -- a period that encompasses the recession and the economic fallout from the Sept. 11 terror attacks -- included some real ugly quarters for many financial-service firms. J.P. Morgan, for instance, reported a $332 million loss in the fourth-quarter of 2001, something that's almost unheard of for a bank of its size and stature. Right now, no one is predicting another loss of that magnitude for any of the nation's leading banks or brokers.

And while many Wall Street financial-services analysts have begun to reduce their earning estimates for the remainder of the year, the expectations for the big banks and brokers weren't too high before those revisions started coming out. Wall Street is banking on 2003 as the year the banks and brokers start posting some robust profit numbers.

"I tell clients that if you are going to invest in the sector you need a long-term orientation," says David Ritter, a financial-services analyst with Argus Research, one of the oldest independent stock research firms. "These are very volatile stocks and you have to be patient. But they seem to have settled in at decent support levels."

Bull Bullish

Ritter, in particular, is bullish on Merrill's long-term prospects. He applauds the nation's biggest brokerage for taking steps the past year to slash its operating expenses by eliminating thousands of jobs and trimming other costs. The job cuts, while painful, will make it easier for Merrill and other financial firms to post higher profit numbers, once the good times return again to Wall Street.

Even the ongoing investigations into the activities of Wall Street firms aren't scaring Ritter. To be sure, he expects some of these stocks to be rocked in the coming weeks by more negative headlines. And he says there's a good chance these institutions will have to pay out big money judgments in some of the many shareholder lawsuits now pending against them.

But Ritter is bullish on beaten-down financial stocks like Merrill because his biggest fear hasn't materialized. Much to his surprise, Merrill hasn't lost many brokerage customers, even in the aftermath of the New York State Attorney General's Office much-publicized investigation into analyst conflicts-of-interest.

"Despite everything that has gone on, Merrill continues to attract money from clients," says Ritter. "There's not been some mad rush for the exits. That really hasn't happened."

But if the threat of more investigations and lawsuits still unnerves you, there is a less risky way to plan for an eventual rebound in the fortunes of some of Wall Street's bad boys. And that's by buying shares in the two main exchange-traded funds that track the performance of the financial sector: S&P's Financial Select Sector SPDR(XLF Quote - Cramer on XLF - Stock Picks) and Barclay's iShares Dow Jones U.S. Financial Sector Index(IYF Quote - Cramer on IYF - Stock Picks).

Shares of both broad-based financial ETFs, which each own a small percentage of shares in stocks like Merrill and J.P. Morgan, are down 11% for the year.

That's not great, but it's a lot better than the 33% slide in Merrill's shares or the 28% slump in J.P. Morgan.