Wall Street Takes Aim at Itself

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All in all, this growing pile of analyst reports represents acute anxiety by big Wall Street firms about their own industry's prospects in the next year.

Investor worries have punished financial stocks and dragged the broader market below its lows in March, the terrifying time when investment bank Bear Stearns was collapsing.

On June 26, S&P's Investment Banking & Brokerage index dropped 4.4%. Citi shares fell 6.3%; BofA's stock dropped 6.8%; Goldman fell 4%; and Merrill's shares lost 6.8% of their value.

Underestimating the Damage

Yet the sudden burst of bearishness from Wall Street analysts, and the resulting plunge in financial stocks, left some market observers scratching their heads. For more than a year, investors have known about serious problems in the financial system, which include toxic investments like risky mortgage-backed securities, frozen credit markets, the impact of falling home prices and a troubled mortgage industry, and, as the economy has weakened, declining credit quality for banks' consumer and commercial lending businesses.

However, when it comes to estimates of firms' financial results, analysts have consistently underestimated the damage the crisis is causing to Wall Street bottom lines.

"The magnitude of the problem was underestimated initially," says James King, president and chief investment officer of the National Penn Investors Trust Co.

Stephen McClellan, at one time a top-ranked analyst at Merrill and Salomon Brothers, criticizes how his former profession has performed in the past year.

"An awful lot of people saw this a long time ago," McClellan says of the financial crisis. "It's a sad commentary on the state of research analysis on Wall Street to be this late in the game."

The Concern Is Genuine

On Wall Street, your competitors are often also your clients and business partners, so almost every financial industry analyst's note necessarily includes a long list of conflict-of-interest disclosures. But various rules and regulations are meant to ensure analysts' independence, and few believe that they are being influenced by their employers to issue negative opinions on their rivals.

The rising concern about the financial industry seems genuine, especially as many banks and brokerage are possibly preparing to issue profit warnings as the quarter comes to an end. Second-quarter earnings at many firms will be issued in mid-July.

"They're real nervous about pre-announcements," McClellan says of his former colleagues. Plus, analysts have a tendency to follow each other. "They don't want to be left behind or look absent from the situation," says McClellan, who retired in 2003 and recently authored the book Full of Bull, a harsh look at Wall Street analysts.

There's another reason so many analysts have sounded so gloomy lately about the financial sector, according to Manny Weintraub, head of Integre Advisors.

Thinking Things Had Hit Bottom

After the Bear Stearns crisis in March, many analysts and investors turned positive on the financial industry. "People were trying to be too cute," Weintraub says, by guessing when the financial sector had finally hit bottom.

A Goldman Sachs analyst, David J. Kostin, admitted on June 23 that the firm was "clearly wrong" when in early May it encouraged investors to bet that consumer discretionary and financial stocks would recover.

Because financial stocks make up a large portion of the U.S. stock market, investors don't want to miss out on a rally for the sector whenever it comes. "There's a lot of nervousness about when to hop back in," Weintraub says. He expects that to add to the sector's volatility throughout the rest of the year.

Financial sector analysts' record for correct predictions in the past year is decidedly mixed. But, if the people who work on Wall Street are to be believed, now is not the time to bet on a resurgence for the sector.

Steverman is a reporter for BusinessWeek's Investing channel.