Why it's time to dump investment banks

By Robert Walberg

Based on a recent flurry of earnings announcements, it's clear that the best days for the investment banking sector are behind it.

Consider that year-over-year earnings comparisons were pedestrian and that sequential drops raised a major red flag. Whereas Lehman Bros.' (LEH, news, msgs) surprisingly strong 31% jump in revenue gave investors false hope for another record quarter for the sector, results from Goldman Sachs (GS, news, msgs) and Bear Stearns (BSC, news, msgs) brought the group, and the market, back to earth.

The biggest culprit was obvious: soft results from mortgage businesses due to the woes of the subprime lending market. Bear Stearns was the hardest hit, with revenues from its mortgage group dropping 21%. Revenue in Goldman's trading and principal investments unit fell 6% from last year and 29% from the first quarter. Even Lehman struggled, with a 14% drop in its fixed-income business.

While all three investment banks were able to offset weakness in their mortgage-related businesses with strong growth from equity trading, asset management and mergers-and-acquisitions activity, how long can the boom persist -- especially now that long-term interest rates are on the rise?

Slowing takeover and trading businesses

In the past month, the 10-year Treasury note yield has shot to its highest levels in nearly a year. The higher cost of borrowing makes debt-financed deals more expensive, meaning that the flurry of takeovers is bound to slow if rates keep rising. Even the mere risk of higher rates could crimp activity as buyers take a wait-and-see approach.

Trading activity is also apt to slow if the U.S. market experiences an extended pullback. The S&P 500 Index ($INX) and the Dow Jones Industrial Average ($INDU) can't continue their relentless assault on new high ground forever. We're already in virtually uncharted waters in terms of how long the market has climbed without even a modest correction. Higher interest rates could easily trigger a pullback of at least 5%. If stock prices begin to slide against the backdrop of rising interest rates and stubborn inflationary pressures, investors are apt to hurry for the sidelines.

Finally, rising interest rates will further depress an already troubled mortgage market. Home sales are expected to remain soft for the remainder of the year, and higher rates will further pressure home owners who hold short-term adjustable mortgages, resulting in more foreclosures.

Put it all together and the picture for the investment banking industry is far less appealing than it was a few months ago. The mortgage business is likely to remain bleak for at least another six months. And the businesses that largely offset weak mortgage businesses in the last quarter aren't likely to grow as quickly.

Toss in tough comparison periods and about the best the group can hope for is single-digit sales and earnings growth for the foreseeable future. If the domestic market experiences a major correction, even those lackluster estimates would prove wildly optimistic.

Time to cut exposure

So what should an investor do? With the stocks of the big four -- including Morgan Stanley (MS, news, msgs), which reports next week -- up an average of 46% over the past 52 weeks, now is the time to take profits. Don't be fooled by relatively low price-to-earnings ratios because the group historically trades at or lower than such levels during boom times. As soon as the market begins to question the sustainability of the group's bottom-line growth, the stocks will come down hard.

Just look at Bear Stearns, which has come 13% off its 52-week high in recent weeks. The same fate is in store for Goldman and Morgan Stanley -- both now hovering near record highs. Lehman will also be pulled down with the group despite its well-executed quarter.

Also note that a weakness in investment banking often precedes weakness in the broader market due to the sector's heavy weighting and high sensitivity to the economy.

So, if I'm right and the best days are behind the group, it may also mean that the best days are behind the overall market -- at least for the remainder of the year. That's why conservative investors may want to start raising cash, beginning by reducing exposure to the investment banking sector.

At the time of publication, Robert Walberg did not own or control shares of any company mentioned in this article.