Midday Musings: Financial Follies

Broker/dealers have led the post-October rally and were up again Wednesday. How long can that continue?
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Financials, especially brokerage stocks, have provided a huge support to the recent market bounce. But a bigger appetite for risk might be yet another sign that this rally will soon run out of steam.

When looking at the performance of the different economic sectors of the

S&P 500 Index

in the fourth quarter so far, financials stand out. As of Tuesday's close, the financial sector is up 4% for the quarter. With a gain of 1%, financials have the third-best sector performance in November's bounce, behind information technology (up 2.53%) and consumer discretionary (up 1.73%).

Financials have the largest weighting in the S&P, representing 20% of the index, meaning its upside has provided particularly strong support to the S&P's bounce from the October lows.

Shares of the big broker/dealers, including

Goldman Sachs

(GS) - Get Report

,

Lehman Brothers

(LEH)

and

Bear Stearns

(BSC)

, have done especially well after posting blowout results in the third quarter.

As of Tuesday's close, the Amex Broker/Dealer Index has rebounded nearly 11% from its Oct. 13 low of 167.21. On Wednesday, the index was recently up 1.4%, helping push the

S&P 500

higher by 6.56 points, or 0.54%, at 1225.15. Broker/dealers shares were among the main gainers Wednesday, including

AG Edwards

(AGE) - Get Report

,

Legg Mason

(LM) - Get Report

and online broker

E*Trade

(ET) - Get Report

.

Energy shares also gained, including

Exxon Mobil

(XOM) - Get Report

and

Sunoco

(SUN) - Get Report

, despite weakness in crude prices and the "windfall tax" hearings on Capitol Hill.

Elsewhere, the

Dow Jones Industrial Average

was up 49.07 points, or 0.47%, at 10,588.79, and the

Nasdaq Composite

was up 9.69 points, or 0.45%, at 2181.76, thanks in part to strength in

Broadcom

(BRCM)

, which made positive comments at its analyst day meeting.

Banking on Performance

Those wondering if the financials can continue their strong performance ought to consider a related question: How have these firms made their money given the market's relatively dull performance?

The high-fliers of the third quarter have basically resorted to turning into hedge funds. For instance, Goldman's proprietary trading revenue -- trading financed with its own money -- surged 88% in the third quarter; Lehman's grew by 71%. Given the veil of secrecy surrounding proprietary trading, it's impossible to know exactly what Goldman or Lehman (or any other firm) invested in so successfully -- or what kind of leverage was employed.

But one thing is for sure, analysts say, you can't bank on the same performance every quarter.

"We think it's a blip," Rachel Barnard, financial services analyst at Morningstar, says of the broker/dealers' third-quarter performance. "Proprietary trading is incredibly volatile and a good quarter can be followed by a terrible quarter," such as what befell

J.P. Morgan

(JPM) - Get Report

in the second quarter.

Over the long run, Goldman remains a good investment, Morningstar believes. But the current run-up in its shares -- nearly 15% from its Oct. 13 low of 112.95 to Tuesday's close -- might be a bit overboard. Morningstar's fair value price target on the stock is $110.

And then there are the others, such as Bear Stearns, which has met success until recently by investing in mortgages, and Lehman, which is a bond powerhouse. They very well may be making their money elsewhere this quarter, but that's not a given.

For the financial sector as a whole, but especially for banks, there is also still the hope that with inflation expectations rising recently, the spread between short- and long-term interest rates, i.e. the yield curve, may be steepening. Banks typically make money by borrowing on the shorter term and lending for the longer term, typically at higher rates. A flat (or inverted) yield curve can dramatically decrease or eliminate this profit center and the recent rise in long-term yields -- and steepening of the curve -- is one reason for the sector's upside flurry.

Longer-term Treasury bond yields have risen convincingly over the past two months amid higher inflation expectations -- the 10-year's yield has risen from 4% on Sept. 1 to as high as 4.67% on Friday. But with the

Federal Reserve

continuing to lift short-term rates and promising more to come, short-term rates are still rising at a faster pace.

Some observers, such as Bill Gross, managing director of bond powerhouse Pimco, believe that the economy will slow down enough next year to stop the Fed's tightening campaign. But for the money lenders, a slowing economy usually raises the risk of credit losses, especially after an extended period of easy money and high risk-taking as has been seen over the past few years, says Barnard.

In the meantime, bond prices are expected to continue falling and their yields rising, which was the case Wednesday after two days of rising prices and falling yields to start the week.

On Wednesday, the Treasury auctioned $13 billion worth of five-year notes, which received strong overall demand. But as in Tuesday's auction of three-year notes, Miller Tabak notes there was a very weak showing from indirect bidders, which include pension funds, hedge funds and foreign central banks.

Now dealers that had loaded up on bonds ahead of the auctions fear that Thursday's auction of 10-year bonds might show the same trend. This would force many dealers who had purchased bonds ahead of the auctions to unload their positions, likely putting further downward pressure on bond prices.

In recent action, the benchmark 10-year Treasury bond was down 14/32 in price, while its yield, which moves inversely, rose to 4.62%. With bond yields at these levels, and the current leaders of the stock market proving to be increasingly risky bets, the days of the current rally appear numbered.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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