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The test begins on Jan. 1.

After roughly three years of consolidation that created behemoths like


(C) - Get Citigroup Inc. Report


Morgan Stanley Dean Witter


and the pending merger of

Chase Manhattan



J.P. Morgan

(JPM) - Get JPMorgan Chase & Co. Report

, 2001 will bring a market that resembles in no way the runaway train of the late 1990s.

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Stock in the Spotlight 2001: Emerson Electric

The new financial giants will have to prove to investors that they've diversified enough so their broad fortunes still aren't tied to underwriting fees from a bubbling initial public offering market or the proprietary trading gains that became so commonplace during the past few years.

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They'll have to show that they've steered clients into fee-generating accounts as profit margins on trading commissions continue to evaporate. They'll also have to show they can offer many of the services banks have traditionally handled.

The carnage the sector has seen since early December may be based in part on the degree to which firms such as

Goldman Sachs

(GS) - Get Goldman Sachs Group, Inc. Report

and Morgan Stanley have tied themselves to technology stocks. In 1999, for instance, more than 558 initial public offerings found their way to the market, the preponderance of which were technology-related. That number fell to 460 in 2000 as the Internet sector that had generated much of this activity crumbled.

"Because the brokers became so mo-mo, there's now an extremely high correlation between those two groups

brokerage firms and tech stocks," says one hedge fund manager who specializes in financial stocks and owns most of the major firms. "In terms of the

IPO calendar and trading volumes, it's going to be a very tough year-over-year comparison."

Low Flow

The 2001 IPO pipeline isn't exactly brimming with prospects, which cuts significantly into revenue streams at firms such as Goldman and Morgan Stanley. And equity trading volume in 2000 has shown flashes of life, but it's nowhere near the bustling activity of 1999.

Absent a buoyant IPO market and the kind of stock moves that make proprietary trading lucrative, brokerage firms will dedicate 2001 to finding ways to increase profit margins in the retail brokerage business and living off the revenue streams created by asset-management fees.

First Union Securities

analysts Meredith Whitney and Doug Sipkin say they see

Merrill Lynch



Lehman Brothers


and Morgan Stanley as leading the pack among brokers trying to diversify their revenue streams. (First Union hasn't done recent underwriting for any of the firms.)

"Over the last four years, the group of brokers have de-leveraged themselves, evidenced higher levels of annuity style revenue, and further diversified their revenue models," the analysts said in a recent report.

You Mess With the Bull, You Get the Horns

Merrill has long been revered in the industry for using its almost $1 trillion in assets under management to generate fees that cover much of its overhead. It's making similar headway in banking, building its deposit base (according to the First Union analysts) from virtually zero in 1999 to about $38 billion by the third quarter of 2000.

Productivity, strangely enough, will be another test. Merrill and Goldman are making high-profile efforts to migrate smaller individual-investor accounts to electronic trading platforms, thus freeing brokers to chase new clients and fee-generating assets. Merrill's new retail brokerage head, Stan O'Neal, is focusing on raising profit margins from their current 13%-to-14% levels.

As of last week, Merrill was up about 50% and Citigroup over 20% on the year, but Goldman and Morgan shares had lost more than 7% and 4.5%, respectively. The hedge fund manager is hoping investors see the brokerage stocks as "a relative game. Maybe as they become cheaper, they become more compelling."

But whether they actually do may depend more on their ability to break away from the cyclical businesses they've counted on so much in the past.