Fortunes Diverge for Bank, Brokerage Shares

Wall Street firms rally while banks bring up the rear.
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There's a weird divergence going on with financial stocks.

Up until Friday's selloff, brokerage stocks have been on a tear this year, adding to the hefty gains they posted in 2005. The Amex broker/dealer index is trading near its all-time high, up 5% since Jan. 1 and up 36% since the end of 2004.

For bank stocks, it's been a totally different story. The Philadelphia KBW Bank Index, after rising more than 2% in the first two weeks of January, is now in full retreat. The index is down 1% for the year, back to where it was at the end of 2004.

The different paths being taken by brokerage and bank stocks in 2006 is throwing a monkey wrench into the conventional wisdom that financials generally move in lockstep.

"It's an odd situation," says Michael Stead, manager of River Aire Investment, a hedge fund that invests in financials.

The simple explanation for the separate paths being taken by brokerage and banks stocks is earnings. This week, brokers such as

Merrill Lynch

(MER)

and

Jefferies

(JEF) - Get Report

both reported impressive fourth-quarter earnings that exceeded expectations by wide margins. Meanwhile, bank earnings have ranged from disappointing to plain bad.

The list of banks announcing less-than-sterling results include

Citigroup

(C) - Get Report

,

Commerce Bancorp

(CBH) - Get Report

,

Fifth Third

(FITB) - Get Report

,

J.P. Morgan Chase

(JPM) - Get Report

,

Washington Mutual

(WM) - Get Report

and

Wells Fargo

(WFC) - Get Report

.

Citigroup's earnings Friday were

particularly disappointing to Wall Street. Sure, the world's biggest financial services firm reported a 30% gain in profits, but those results were juiced with a $2.1 billion gain on the sale of its asset-management division. The real story at Citigroup was the dismal performance of its U.S. consumer banking group, which reported a 33% decline in net income to $1.4 billion.

Like many lenders, Citigroup is struggling with the disappearing spread between short- and long-term interest rates, which crimps the profitability of loans. The so-called flattening of the yield curve is hammering margins at many lenders and resulting in only modest gains in net interest income.

Worse, the yield curve has actually inverted a few times this year. That's the unusual phenomenon -- which occurred earlier this month -- in which the yield on short-term Treasury notes is actually higher than the yield on longer-term government bonds.

The inversion of the yield curve makes it particularly difficult for banks, which generate much of their profits by investing customer deposits into interest-bearing securities, such as mortgage-backed bonds. The flattening yield curve has all but wiped out the so-called carry trade, the ability of banks to borrow on the cheap and reinvest the money in longer-term mortgage-backed securities.

A flat or inverted yield curve isn't good for brokers either. But Wall Street firms such as

Goldman Sachs

(GS) - Get Report

,

Lehman Brothers

(LEH)

and Merrill Lynch are much less dependent on lending spreads for generating profits than banks.

"I would rather own the brokers in a flat yield curve situation,'' says Stead. "The brokers don't get penalized for business that is going away like the carry trade."

Brokerages, meanwhile, are feasting on all the fees they keep raking from the surge in corporate mergers announced last year. The stocks have been rising on the expectation of even more deals to come this year and a continuing corporate demand for debt underwriting.

The investment banking divisions at Citigroup and J.P Morgan were the saving grace for those big commercial banks in the fourth quarter.

Another thing that's been propelling the brokerage stocks is Wall Street's ability to reap huge profits from trading bonds, stocks and commodities. Trading revenues are hard to predict. Usually the analysts who cover the brokers get it wrong, underestimating the prowess of the traders at Goldman Sachs, Lehman and Bear Stearns to make money from both a surge and selloff in oil prices.

For whatever reason, the big banks with trading desks often can't seem to get it right. The weak spot in J.P. Morgan's fourth quarter was a 24% decline in trading revenue, something the bank attributed to bad bets on energy trades. The thing is, the bank's trading desk has a history of erratic behavior-- posting as many good quarters as bad.

You just don't see those kinds of erratic trading results at Goldman Sachs or Lehman.

While earnings have driven stock prices recently, there's another possible explanation for the underperformance of bank shares. The stock market is often described as a discounting mechanism that forecasts economic conditions six to nine months down the road. Nowhere is this more true than in the financial sector.

Maybe investors in bank stocks see bigger problems looming in the future.