Financials Fly High Lately but Have Flickered Overall

Some fret about financials' lack of punch despite much Fed easing. Others see recent gains as the start of something beautiful.
By Robert Mann ,

SAN FRANCISCO -- "When does tech bottom?" remains the most frequently asked -- and vexing -- question for most investors. But the query, "Why haven't financials done better?" has also been weighing on the minds of market professionals, at least until very recently.

Financial stocks have acted as bulwarks this week, supporting major averages from more tech woes.

Better-than-expected earnings from

Morgan Stanley Dean Witter

(MWD)

, which

followed solid results from

Lehman Brothers

(LEH)

and

Bear Stearns

(BSC)

earlier in the week (although

Goldman Sachs

(GS) - Get Report

disappointed) helped fire up the group today. The

Amex Broker/Dealer Index

rose 3.4%, while the

Philadelphia Stock Exchange/KBW Bank Index

climbed 3.5%.

With financials leading the way, the

Dow Jones Industrial Average

rose 0.6% and the

S&P 500

gained 1.1%, while the

Nasdaq Composite

climbed 1.4%.

But the recent upturn does not change the bottom-line reality: Financials, as a whole, have not fared well since the

Federal Reserve

began its easing campaign. Despite recent gains, the Broker/Dealer index is still down 17.5% since Jan. 3, while the Philly bank index is off 1.4%. The

NYSE Financial Index

is down 3.3%, while the

Nasdaq Financial Index

is up 2.3% in the same time frame.

Overall, that's just not the kind of performance you'd expect from financials after 250 basis points of Fed easing within six months. That financial stocks benefit from lower interest rates is one of the time-tested truisms on Wall Street. The BKX was up nearly 30% six months after the Fed started easing in September 1998, and financials also fared well after Fed easings in late 1990 and 1995.

The performance of financials this year "definitely falls into the category of 'something is different this time,' " said Douglas Cliggott, market strategist at

J.P. Morgan Chase

. "It is a very unusual situation."

Financials haven't fared better in the current easing cycle for some obvious reasons. The stock market has remained mired in a downturn, cutting off the industry's commission business as well as more lucrative underwriting activities. Additionally, many financial firms generated big windfalls in the late 1990s from venture capital operations but have been hurt this year as those investments soured dramatically;

J.P. Morgan Chase

(JPM) - Get Report

and

Wells Fargo

(WFC) - Get Report

being prominent examples.

Furthermore, financial institutions such as

Bank One

(ONE) - Get Report

have been saddled with

nonperforming loans because of the economic and market slowdowns.

"Until

investors get some confidence to at least see some visibility of the end of the loan-loss mountain, you don't have the complete all-clear" to invest in financials, said David Orr, chief capital markets economist at

First Union

in Charlotte, N.C. "More Fed easing ought to

help, but you still can't see it" yet.

Orr, among others, also noted that the yield on the two-year Treasury note has been below the

fed funds target rate for much of the year. This has denied financial institutions the easy money phenomenon known as positive carry, which occurs when firms can invest at rates higher than the prevailing borrowing costs.

To hard-core cynics, the fact that Fed easing has yet to revive either the economy or equities, financial stocks most notably, is a harbinger of Armageddon. The U.S. economy is just now starting to pay the price for the excesses of the late 1990s, they say, and no amount of Fed easing can prevent a Japan-style downturn (and that's if we're lucky).

While J.P. Morgan's Cliggott has been

pretty dour about the outlook for corporate earnings and stocks, he's not (

repeat: not

) among the Cassandras singing the siren song for U.S. capitalism.

The "best explanation" for why financials have struggled this year is that Fed easing has prompted long-term bond yields to rise, rather than fall, he said. "The standard issues confronting financials when economic growth slows -- worries about credit quality and growth of the top line -- are usually overwhelmed by the balance sheet benefits of

long bonds'

prices rallying. But you're not getting that this year."

Heading into today's session, the yield on the benchmark 10-year Treasury note was up four basis points since Jan. 3, and 42 basis points since its low on March 22. Similarly, the yield on the 30-year bond was about 17 basis points above its Jan. 3 level and nearly 40 basis points higher than its March low.

J.P. Morgan has found "pretty good statistical relationship" between the performance of financial stocks and the direction of bond yields, Cliggott said. Bond yields go up, financials struggle and vice versa.

Not surprisingly then, financials have done well this week as yields of long-dated Treasuries have fallen. Today, the price of the 10-year note rose 7/32 to 98 22/32, its yield falling to 5.17%. The price on the 30-year bond rose 17/32 to 96 12/32, its yield falling to 5.63%.

Bond yields have fallen this week in conjunction with inflation fears, which have retreated as energy prices dropped sharply. Although I don't believe the inflation story is over -- note the spike in the prices paid index in today's

Philadelphia Fed

survey -- recent action in both financials and bond yields has

emboldened some observers. The implication is that a period of more dramatic outperformance by financial stocks is about to begin.

Scratching Beneath the Index

Those adhering to such a scenario should pay heed to the views of Tom Brown, CEO of

Second Curve Capital

, an approximately $400 million hedge fund that invests almost exclusively in financial stocks.

It is disingenuous to say financials haven't done well this year simply because industry indices have sputtered. Brown contends: "Some stocks have done extremely well, and some have done poorly. The market is correctly saying that interest rates are just one factor in the earnings outlook for financial stocks."

As with the broader market, mid-cap financials have outperformed larger names this year, he said, noting mid-caps generally don't have venture capital arms or expensive capital markets operations.

Examples of solid performers include

Dime Bancorp

(DME)

,

City National

(CYN)

,

Commerce Bancorp

(CBH) - Get Report

and

Golden Sate Bancorp

(GSB) - Get Report

.

Going forward, the hedge fund manager is optimistic about what he called "distressed banks getting better," including

Bank of America

(BAC) - Get Report

,

UnionBanCal

(UB)

,

Hibernia

(HIB)

and

Sovereign Bancorp

(SVRN)

.

Second Curve Capital has long positions in each of the aforementioned.

The latter group was "overly depressed last year by concerns about credit quality deterioration," Brown said. Their prospects will recover as the economy revives in the second half of the year, he said, expressing confidence a rebound will emerge, largely because of Fed easing.

Second Curve's net long exposure is currently running at the high end of its self-mandated parameters, he continued. But he stressed there are some companies where credit quality problems are "just beginning."

Brown declined to discuss specific shorts, other than to say he is looking for names in regions in which economic weakness has been most pronounced. He also declined to discuss the fund's performance, other than to say, "if you're a hedge fund, this is the type of year you love, because some

stocks are doing well, and some are doing poorly."

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.

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