The White House proposal to rein in risk-taking among financial firms spooked the stock market amid worries about bank profits. But investor fears may be overblown
President Barack Obama's tough talk against Wall Street rattled stocks on Jan. 21. And, market observers warn, this could be just the beginning of a tough political year for investors. It was Obama's tone as much as his proposal—to limit growth and risk-taking by big financial institutions—that raised eyebrows. The plan would prohibit banks from running proprietary trading operations or investing in hedge funds and private equity funds. News of Obama's plan arrived before the stock market opened Jan. 21, but the broader indexes and affected bank stocks headed solidly lower when Obama actually stepped to the podium before 12:00 p.m. ET. Speaking of the "army of lobbyists" fighting tighter financial regulations, Obama said, "If these folks want a fight, it's a fight I'm ready to have." The broad Standard & Poor's 500-stock index ended the day down 1.9% to 1116.48, its second consecutive day of steep losses. Wall Street investment bank Goldman Sachs (GS), which reported a record quarterly profit on Jan.21 fell 4.1% to 160.87, while JPMorgan Chase (JPM) dropped 6.6% to 40.54 and Bank of America (BAC) lost 6.2% to 15.47. "We knew the regulatory environment would provide a headwind for the market as we got closer to the 2010 election," says Quincy Krosby, Prudential Financial (PRU) market strategist. But the Jan. 19 victory by Republican Scott Brown in the Massachusetts Senate contest seems to have ramped up the political risk for shareholders, she says. By eroding Democrats' chances of easily approving health-care reform, the election seems to have prompted Obama to take aim at politically unpopular Wall Street instead. The Upheaval of Uncertainty
When asked, many market experts say they do favor some form of financial regulation. The problem for investors and traders is not so much the proposals themselves, but the uncertainty they create while under discussion. "The market hates uncertainty, [and] any horse-trading involved in passing legislation introduces uncertainty," says independent market strategist Doug Peta. A prime example is health-care insurers, who have seen their stocks hurt by Washington's ongoing discussion of health-care reform. Market participants, who tend to be politically conservative, also fear the impact of government regulations on profits and economic growth. "In general, the market would prefer the government stay out of it," Peta says. The last 10 months have been good to financial stocks, as many banks, helped by low interest rates and rising markets, have returned to profitability. For traders, Krosby says, "the immediate reaction [on Jan. 21] was: Take profits now, ask questions later." Eventually, the market may appreciate Obama's tougher approach, says Jeffrey Hirsch, editor-in-chief of the Stock Trader's Almanac, who believes the proposed changes could over the long term "shore up the integrity of the system." But, on Jan. 21, the market appeared to show a more emotional, knee-jerk reaction to Obama's plan, he says. "It's like a child who is being told not to do something," Hirsch says. " 'Don't take my toy away'—that's a natural reaction." Frank: Regulation Implemented Slowly
Obama's six-minute address left traders and investors searching for information on how the proposal would affect financial stocks, says Dave Rovelli, managing director of equity trading at Canaccord Adams. "Who is going to come in and buy a financial stock…if they don't know what the rules are going to be?" he says. At least some uncertainty was lifted when House Financial Services Committee Chairman Barney Frank (D-Mass.) told media any regulation would be implemented slowly, perhaps over five years. Otherwise, he told Bloomberg TV, "you create fire-sale conditions," in which banks are forced to sell off assets quickly. "We are aware that you don't want to be doing it all at once." Frank even said he expected Goldman could skirt the new rules by simply ending its status as a bank holding company. After his comments, financial stocks rebounded a bit. Obama's proposal wasn't the only reason markets fell on Jan. 21. In Asia, many investors were worried about a potential overheating of China's economy, and efforts by its government to slow down growth. After significant gains in the last two months, some technical analysts were telling traders the market was due for a pause. It can be a mistake to attribute too much stock market impact to political events. "It may have some short-term effect here and there," says Richard Sparks of Schaeffer's Investment Research. The effects are often limited to particular sectors, like health care or financials. And, Sparks says, "over the longer term, earnings are going to be the engine that drives the market." Other big factors influencing stocks include economic data, the U.S. jobless rate and the direction of interest rates set by the Federal Reserve. Wall Street vs. Washington
Still, the stock market seems to have entered a period when discussions in Washington have taken on added significance. "There is a lot of political risk because the [country's] problems are so big," says John Merrill, chief investment officer at Tanglewood Wealth Management. The government has spent decades avoiding fiscal problems, for example. "This is a can that's been kicked down the road for years," he says. The market's Jan. 21 sell-off may be a one-day blip, the reaction to a proposal that—if financial industry lobbyists have their way—may never become law. But it is also a reminder that the factors affecting the stock market are changing. With a fresh wave of regulation looming—and investment bankers the political bad guys of the moment—Wall Streeters will no longer find Washington such a hospitable place.