As Washington Turns on Wall Street, Investors Should Expect a Rough Stretch for Financial Stocks

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Here in the United States, investors have been startled by the realization that Washington no longer appears to be acting as a benefactor to Wall Street, the financial markets, and the economy. Ever since the collapse of Lehman Bros. Holdings Inc. (OTC: LEHMQ) back in 2008, a Faustian deal was forged between Wall Street executives and the politicos in Washington: Ideologies would be thrown by the wayside to prevent a meltdown of the American financial system and the precipitous collapse of the economy.

First, the Bush administration swallowed its free-market credentials to take over Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), while handing the largest banks and the Detroit automakers big piles of taxpayer cash to keep them afloat. Then, the Obama administration resisted populist pressure to punish the bankers getting rich thanks to rising financial markets while unemployment continued to climb.

But that's changing now, and the attack dogs have been unleashed. Policy is moving from supportive (crisis management) to restrictive (crisis prevention and the scoring of political points) at a faster pace and to a much-more-severe degree than many imagined.

It started with extra taxes on bank liabilities to fund a reserve for financial crises, then moved to include a congressional commission to review the causes of the financial crisis, and then to more onerous regulatory oversight. But now it's growing into something more. And that's one big reason stocks in general and the financial sector in particular sold off so severely.

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Government officials hypocrisy is amazing. I am not dismissing the bank's role …

Volcker Plan Falls Short

Wall Street thought that White House sympathizers - such as U.S. Treasury Secretary Timothy Geithner, U.S. Federal Reserve chairman Ben S. Bernanke, and economic advisor Lawrence H. "Larry" Summers - could hold off the likes former Federal Reserve Chairman Paul A. Volcker and others who wanted to bust up the big banks. The unspoken threat against drastic action was that any action to please the masses and take on the banks would upset the financial markets and risk plunging the economy into a second recession.

On the other hand, Volcker and others believed that instead of laying the groundwork for a robust recovery, the banks were returning to their old sinful ways - secure in the knowledge that taxpayers would be there as a safety net if troubles returned. Without action, we risked another calamitous financial meltdown. The skeptics wanted a return in spirit to austere Great Depression-era legislation that separated deposit-taking commercial banks from riskier investment banks. These people had the support of an angry electorate suffering from high unemployment and a ruined housing market.

After the Democrats lost their filibuster-proof majority in the Senate on Tuesday, the Democrats realized that they needed a change of tone if they are to survive the November midterm elections. Now they're targeting the banks, siding with the Volcker camp, and putting on their battle armor.

U.S. President Barack Obama made a speech in Ohio that dripped with aggressive populism - castigating the healthcare industry for "scaring the bejesus out of people" with ads against healthcare reform while whipping the audience into a chorus by demanding Wall Street return taxpayer money.

Also unsettling markets is the plain fact that the Volcker plan is short on details, and on its surface does not address the real causes of the recent financial crisis. The plan proposes to strip banks of proprietary trading desks and sponsorship of hedge funds, and prevent them from getting too big to fail. But none of those issues was at the heart of the crisis.

Chris Whalen, an excellent bank analyst at Institutional Risk Analytics, said in a note to clients on Sunday: "Neither prop trading nor the size of the largest banks are the causes of the financial crisis. Instead, opaque over-the-counter [derivatives] markets, deliberately deceptive structured financial instruments and a general lack of disclosure are the real problems. Bring the closed, bilateral world of [the] OTC market into the sunlight of multilateral, public price discovery and require SEC registration for all securitizations, and you start down the path to a practical solution."

Whalen further points out that Volcker has no credentials as a reformer. He made his reputation as an inflation fighter, and both he and his proteges were known during their administration of the Fed as friendly and supportive of Wall Street. By steering the debate toward the mostly irrelevant issue of prop desk trading and support of hedge funds, Whalen suggests that Volcker has deliberately shielded the Street from rules that would actually hurt their business.

In short, Whalen accuses the Obama administration of combining demagoguery and deception. If he's right, the public ends up with the worst of both worlds: months of unsettled regulation and no real reform.

Rough Waters Ahead for Financial-Sector Stocks

If markets were in a buoyant mood, and anxious to take risk, they would ignore these troubles and bid investment banks and big commercial banks up anyway, climbing the proverbial "wall of worry." This occurs when investors fundamentally believe the worry is misplaced. When they think the worry is understated, the catch phrase instead is that the stocks will slip down the "slope of hope." It now looks like this alternative is the operating framework.

A month ago, I recommended SPDR KBW Capital Markets ETF (NYSE: KCE) an exchange-traded fund (ETF) focused on the i-banks and brokerages. My logic was simple: I was expecting the sector's problems to be brushed under the carpet as the Obama administration focused on healthcare reform over financial reform. But the loss of the Democrats' Senate seat in Massachusetts appears to have pushed the White House to turn on a dime and pick a new victim.

Big brokerages are under assault - and they should be. Owning a group that is under assault by a government motivated by a murky swirl of populism, revenge and jealous rage is probably just not a good idea.

Even if plans for bank reform are de-fanged by the time the legislation works its way through Congress (not to mention its accompanying gauntlet of lobbyists) investors will continue to focus on "worst-case" impacts on profitability.

Given these bottom-line concerns, it's no surprise that such bellwether stocks as Goldman SachsGroup Inc. (NYSE: GS) andMorgan Stanley (NYSE: MS) are falling below their 200-day moving averages for the first time in 10 months.

Overt populist warfare against industry can get ugly. The Pujo Committee of 1912 was formed to investigate the large Wall Street banks accused of wielding too much power over the country. Men like J.P. Morgan were hauled before Congress and grilled. A few months later, the great banker, steel magnate and rail tycoon died.

Also keep in mind that the terrible 1907 Panic had many causes, but one was the rise of populist fury against large companies like Standard Oil led by trust-busting president Theodore Roosevelt.

Broad Market Pause Means Stock-Picking Skills Will Be Key

All of these surprise developments provide the context for the stock-market pause we've been expecting as indices like the Standard & Poor's 500 Index pull back from overbought levels and return to a more even keel relative to their long-term moving averages. History has also shown us that stocks normally consolidate with a downward bias as central banks prepare to lift interest rates.

Even though we expect the broad market to cool its heels for a time, there will be plenty of opportunity to use technical- and fundamental-stock-picking skills to profit from individual sectors and from stocks that will rise in anticipation of the next phase of the bull market.

In our Strategic Advantage advisory service, we plan to aggressively attack opportunities as they arise with a portion of our recommended ETFs. Stay tuned.

[Editor's Note: With the U.S. economy picking up steam, there has seldom been a better time to invest. Valuations are low and the potential for profit is extraordinarily high. But picking the right investments is key - and having a guide is crucial. Jon D. Markman should be that guide. Markman, a veteran portfolio manager, commentator and author, is offering investors a unique opportunity to capitalize on the current bull market by subscribing to his Strategic Advantage newsletter. For more articles like the one you just read, or for more information about Markman's Strategic Advantage service, please click here.]

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