Stop Taking Risks Bottom-Fishing in Financials

IN JUST SIX SHORT weeks since it hit a bottom on July 15, the financial sector of the S&P 500 is up a scorching 24.3%. I told you then, when the drama of a possible collapse of Fannie Mae (FNM) and Freddie Mac (FRE) first started to unfold, that this was all much ado about nothing.

Even as the overall sector recovers, the drama of the two GSEs continues. Just one week ago, Fannie and Freddie hit new lows. Nevertheless, it seems as if the world has come around to the view that I expressed in July: that the GSEs are going to survive. Both stocks have doubled from the bottoms they hit on Thursday of last week.

A speculator's dream? Perhaps. But I think that the financial sector is an investor's nightmare. Try to catch the precise bottoms if you can. But how many of us are that lucky or that skillful?

On Aug. 1, I laid out a case for why the financials were no bargain -- even though I'm confident they aren't going to zero. At that point, the sector was up 25.7% from the July bottom. Alert readers, who compare that number to the one I cited in the first paragraph, will draw the correct conclusion that the sector has actually lost money for investors since Aug. 1 -- 1.1%, to be precise.

So timing is everything. Which means it's all about speculation, and not about investing. Don't get me wrong -- there's nothing wrong with speculation. It's a noble calling. I speculate quite a bit myself. But let's not confuse it with investing.

In this market there are lots of better ways to invest than trying to get lucky with financials. I'll get to my favorite investment idea in a moment, but first I'd like to lay to rest any ideas that investors are harboring about buying the financial sector for the long term.

First, let me reiterate that I don't think the financial sector is going to go to zero, as so many investors seem to fear. Second, when the wave of fear that's now engulfing the market dissipates, I have no doubt that the embattled financial sector will have a good upside run. My point is that long-term -- and I'm talking about, say, over the next 12 months -- I think it's very unlikely that the sector will be a top performer.

Many of my institutional clients, however, believe that financials will be a top performer. They remember the spectacular long-term run that the sector had coming out of the savings and loan crisis in the early 1990s. In some ways, it's a good comparison: There certainly is a crisis now, and, just as in the earlier episode, we will indeed come out of it. But other than that, the comparison doesn't match up.

Once the S&L crisis was dealt with, the financial sector grew to be the largest sector in the S&P 500 -- in terms of the number of companies, total market cap and earnings. Thanks to the current crisis, it still has the largest number of names -- but it has lost the other two distinctions.

The financial sector's success coming out of the S&L crisis was due to the convergence of four very powerful megatrends: consolidation, automation, globalization and securitization.

Financial firms were able to grow earnings and achieve efficiencies by acquiring smaller rivals. They were able to improve margins by exploiting the inexpensive computer and networking power that suddenly became available. They achieved economies of scale by expanding globally. And they profited from new methods of bundling up traditional loan products into easily-traded securities.

So after all that, what do you do for an encore? At this point, consolidation won't be about achieving efficiencies -- it will be about survival. Automation? Been there, done that. Globalization? Ditto. And securitization? That process is going to run in reverse, with sophisticated new ways of packaging products reverting back to the clunky old ways of the past -- because the complexities and opacity of securitization have been blamed for the subprime loan fiasco.

So what, exactly, is the financial sector supposed to do for earnings growth?

I can tell you it's not going to be subprime lending. A couple years ago, when this sector was on top of the world and capable of doing anything it wanted, subprime lending was what they chose to do. That was their best idea: Lending money to people who couldn't pay it back.