Who loves ya, baby? If you're a bank or an insurance company, this question might prompt an embarrassing silence. No other segment of the modern economy has been viewed with suspicion so consistently by demagogues of both left and right.

But they were always good businesses to own, no? They had nice operating margins, heavy government regulation of their industry to keep out those pesky competitors, and two product lines absolutely guaranteed to be around forever: management of money and risk. Just as every two-bit celebrity has to buy a restaurant to confirm his or her status, every would-be mogul gets involved in the money game sooner or later.

During the early phases of the bull market breakout beginning in 1995, financial stocks -- banks in particular -- were standout performers. Much of this had to do with a wave of mergers and consolidations in the industry as Depression-era restrictions on interstate banking fell. In addition, banks benefited enormously from lower inflation and interest rates, and from the

Bank of Japan's

manic creation of liquidity.

They haven't, however, kept pace with the real bull-market babies. The question now is whether the market should follow the leads of country music heroines and First Ladies and forgive the wayward bankers.

Moral Hazard

The relative overperformance of bank stocks ended so precipitously in the summer of 1998 that we can draw a trend line to describe the event. The combination of the

Russian

debt default and the

Long Term Capital Management

fiasco led to an almost-daily parade of global banks confessing to an array of sins best described as greed combined with a complete lack of common sense. The management of financial risk -- the

raison d'etre

of the entire industry -- was, by definition, poor.

Public financial institutions, led by the

Federal Reserve, other central banks, and the

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International Monetary Fund did everything they could to inject liquidity back into the banking system; the Fed explicitly justified its third rate cut in November 1998 by citing wide credit spreads between corporate bonds and Treasuries. Lower short-term interest rates are supposed to be a tonic for banks, but their relative performance continued to slip in early 1999. By the time the Fed embarked on its series of rate hikes in June 1999, the sector was doomed.

Investors have been a very forgiving lot in recent years, as money remains in search of homes that make sense. We have gobbled up firms whose business plans might have embarrassed

Charles Ponzi. We have bid valuations to historically unprecedented levels. The financial services sector is an exception. These stocks have been assigned a risk premium and lower multiples. After all, the banking industry's unblemished record since 1974 of taking on excessive risk and then running to the IMF for a taxpayer-funded bailout will get us in trouble -- big trouble -- one day.

One More Chance?

So, do bankers get one more chance?

Not just yet: First, we have to recall why these stocks were so attractive just a few years ago. Cheap credit, like cheap booze, has a way of making things look better until normal judgment returns. We should expect to see an inverse relationship between the relative performance of bank stocks and short-term interest rates, and we do. While these rates were stable or falling going into the summer of 1998, bank stocks outperformed the

S&P 500

. These rates were driven lower in response to the banks' losses, and once domestic credit conditions started to tighten, bank stocks underperformed as expected.

Credit is a global, and not just a domestic, phenomenon. The Bank of Japan has been flooding its domestic market with cheap credit for years in a vain attempt to revive the

Japanese economy. The unwillingness of the BOJ to drive interest rates below zero, combined with Japan's persistent trade surpluses with the U.S., has led to a renewed strengthening of the yen. The yen's course, even more than Fed policy, explains the relative performance of bank stocks.

Banks, deprived of low-cost money on both sides of the Pacific and forced away from previously profitable lending to emerging markets, have struggled. Management in any industry should earn its keep during tough times; any slob can win a poker hand when dealt a royal flush, and any bank can make money with funds at low cost. Neither should be confused with talent.

Our friends at the Fed have all but declared war on the

Nasdaq

, which is an interesting decision for these nonelected servants of the people. They have been notably unsuccessful in slaying the high-tech dragon with higher interest rates. They have, however, succeeded in clobbering the banking sector, the one segment of the economy directly under their purview.

Howard L. Simons is a professor of finance at the Illinois Institute of Technology, a trading consultant and the author of The Dynamic Option Selection System (John Wiley & Sons, 1999). Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he invites your feedback at

HSimons@aol.com.