A Cautious Eye on Investment Banks

S&P says momentum for stocks of investment banks has

been negative, and maintains a neutral longer-term
outlook for the group
From Standard & Poor's Equity Research

52-Week Relative Strength—Investment Banking & Brokerage

Back in February, based on the rolling 12-month relative price performance through Feb. 23, I
cautioned that the momentum for the financial services subindustry was waning (BusinessWeek,
2/27/07). Since then, the S&P 1500 Investment Banking & Brokerage index has fallen 12.1%,
while the S&P Composite 1500 (consisting of the large cap S&P 500, MidCap 400 and
SmallCap 600 Indices) has risen 1.9%.

This week, many of the I-Banks report quarterly earnings, with Lehman Brothers (LEH) kicking
things off on Sept. 18 (BusinessWeek, 9/18/07). After two months of weathering a credit crunch,
how will they fare, and what will share prices likely do in the near-to-intermediate term? Based
on momentum alone—since the trend and moving average are still heading south—it appears to
me that near-to-intermediate term weakness will persist.

Take a look at the accompanying chart of the subindustry index's rolling, 12-month price
performance compared with that for the S&P 1500. Any point above 100 indicates sector out-
performance vs. the S&P 1500 over the prior year, while points below 100 show sector under-
performance. The red line is a rolling, nine-month moving average, while the two green bands
indicate one standard deviation above and below the index's longer-term mean relative strength.

Long Term Prospects Weakened

Should those investors who are still exposed to this subindustry stay put? Matthew Albrecht, the
analyst who covers stocks of the I-Banks for S&P, has a neutral fundamental outlook on the
subindustry. Although he believes recent events suggest a slowdown in the investment banking
business due to widening credit spreads and the resultant decrease in sponsored finance activity,
Albrecht thinks strong corporate balance sheets and relatively resilient corporate credit markets
suggest strategic acquisitions should support profitability in the sector for the remainder of 2007.

Still, the industry faces tough comparisons vs. last year. S&P also expects continued volatile
growth in commission revenues in the near term, but Albrecht believes long-term prospects have
weakened. He believes that price-to-earnings multiples for many of the stocks in the industry
have been pressured, and the analyst expects that price-to-book value ratios will stagnate
somewhat as balance sheets of some of companies are scrutinized.

Despite difficult comparisons, a number of companies in the industry posted year-over-year

improvements in revenues and earnings for the second quarter and first half of 2007. Revenues
from investment banking had remained strong on mergers and acquisitions advisory and debt
underwriting fees—with trading revenues providing positive upside—and benefited from an
increase in volatility. The online brokers have seen typical seasonal volatility, but a business
more focused on asset gathering has lent a measure of predictability to results.
Underperformance Traced to Subprime

Albrecht expects the companies in the industry—which recently were increasing global
headcounts in order to capture potential deals—to slow hiring somewhat, as the operating
environment has come into question. S&P expects that U.S. headcount may decline, while hiring
should continue overseas in an effort to broaden revenue exposure to diverse economies, thereby
mitigating some risk. Albrecht sees increased price competition among brokerage firms and
expects online discount brokers to continue to expand operations in order to attract more long-
term investors.

S&P believes the group's relative underperformance can be traced to exposure to subprime
mortgages and resultant market turmoil that has affected worldwide credit markets. Despite
recent weakness in the subindustry, Albrecht believes valuations are appropriate at this time, as
the group is trading at a wide discount to p-e multiples of both the S&P 500 and the subindustry's
own 10-year historical average.

So there you have it. The I-Banks' near-term momentum continues to deteriorate, yet the group's
longer-term fundamental outlook is neutral.

Industry Momentum List Update

Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5"
(price performances in the past 12 months that were among the top 10% of subindustries in the
S&P 1500), along with a stock with the highest S&P STARS (tie goes to the highest market
value).