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Three Reasons Investors Should Curb Their Enthusiasm

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Financials may be up -- but it's time to calm down.

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Investor spirits for Financials may have been buoyed by the recent earnings results of the major banks, however, there are at least 3 reasons why such enthusiasm should be tempered. Let's start with the dustup that's emerging between fund giant BlackRock (BLK) and the investment banks.

In today's Financial Times, BlackRock Founder and CEO Larry Fink takes issue with the "luxurious" trading profits generated for major Wall Street firms by large spreads between the bid and ask prices. As Fink sees it, "There are fewer players. There is very little capital being committed by these dealers." When an organization with $2.3 trillion under management grumbles, it's unlikely that such complaints will go unresolved for long. Therefore, it's logical to assume that salad days of "luxurious" trading profits may be numbered.

The second reason for caution regarding Financials is the hording of government money via financial-asset purchases and banks' less-than-enthusiastic willingness to lend the government funds -- which was the public-policy purpose of providing such monies in the first place.

Here, too, an article in the Financial Times brings the issue to sharp focus. As the article points out, commercial banks are parking a substantial sum (most?) of the funds they've received from government in overnight deposits with their respective central banks and "buying government bonds, high-quality corporate bonds and, of late, equities -- in effect recycling the liquidity around the financial system."

Such actions clearly aren't helping the economy overall and are at odds with the role of banks -- which is lending -- and with investors in financial institutions, who will eventually demand that growth opportunities be the paramount consideration of bank management. As every activist investor will tell you, businesses are in the business of generating rates of return in excess of their cost of capital. Firms that fail to do so eventually suffer the consequences of reduced investor interest -- lower stock prices, in other words -- and possibly, aggressive activist shareholder action.

The third reason for concern with Financials centers on the quality of earnings via the reduced need to mark-to-market assets held on the books. It's one thing to advocate for the elimination of mark-to-market accounting for illiquid assets (as I've done since March of last year). It's quite another, on the other hand, to endorse the historical cost accounting of same assets. Somewhere between the 2 lies the real "fair value" of such assets. However, when banks choose not to reflect some deterioration in such troubled assets' values, then you end up with inflated performance numbers.
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No positions in stocks mentioned.
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