The significant correction, which I predicted in my January 15, 2010, post “The Era of Consumerism has Ended” is now underway.  My rationale for my prediction one week ago was because the major market indices had climbed back to their pre crash levels and bullish sentiment had hit its highest levels since February of 2010.

With the change in the political winds for the banks and financials I expect that this correction will be prove to be particularly brutal.  I also predict that the highs for the Dow 30 and S&P 500 that were hit on Tuesday January 19^th will prove to be the high water mark for the breathtaking 10 month rally which began after the market traded to eleven year lows in March of 2009. 

Investors should be extremely cautious.  I am already reading and hearing that this is the expected 10% correction that everyone has been waiting for.  I am still of the belief that we have not yet seen the lows for this bear market.  However, due to the immense liquidity which was created by the government for the banks, I had, prior to President OBama’s announced regulatory reforms on January 20, 2010, resigned myself to taking the position that the major indices would experience a much more gradual rate of descent than the rate that investors experienced between October of 2008 and March of 2009.  My resignation was based on the fact that I did not believe that there would be any significant financial reform.  I now do believe that financial regulatory reform will be significant.  See more below in this report.  It would not surprise me one bit to see the major indices, which have not experienced even a 10% correction over the last ten months slice right through a 10% correction point like a hot knife through butter.  I would avoid buying on a 10% correction and would certainly recommend having 80% of a portfolio in cash equivalents or U.S. Treasury bills. 

The driver of the significant blood letting that I am predicting will occur for the stock market over the next several months is the recent announcements by President Obama regarding his administration’s newly proposed taxes and regulations that they intend to slap on the banks and financial institutions.  The posture that Obama only recently adopted signals a radical shift in his behavior toward the big banks.  I believe that most investors do not yet understand the significance in how this behavioral change can and will have a dramatic impact on the equities markets over the near term. 

After being inaugurated in 2009, it became clearer as the year went on that Obama’s priority was not financial regulatory reform.  Based on his initial behavior towards the banks it appeared as though he was coddling them.  I myself was somewhat befuddled that it was not the top priority of a new Democratic Administration to make bank or financial regulatory reform the number one issue.  This was especially since only months earlier the U.S. banking system had faced and had narrowly avoided Armageddon.  Due to Obama’s lack of action and his focus on revamping health care as his top priority he and his administration established a reputation of being soft or in coddling the banks.  As health care reform captured an increasingly larger portion of the spotlight many in the electorate and the media began to believe that Obama wanted a major overhaul of healthcare to be his “legacy”.  

As 2009, passed with barely a mention of bank regulatory reform many investors were increasingly lulled into investing into the shares of the recovering financial companies because they believed that the banks had escaped the wrath of having to face draconian regulatory reform.  This false sense of security that investors had regarding financial regulatory reform, or the lack thereof, is why the major indices were able to experience the likes of a 10 month bear market rally in which the S&P gained more than 60% off of its lows of March 2009.  

I now believe that the melancholy approach that Obama and his administration took with the banks in 2009 was by design.  There is little doubt in my mind that this strategy was mapped out by former Fed Chairman Paul Volcker, who is one of Obama’s economic advisors.  After the October 2008, financial upheaval Volcker knew that banks needed the time lick their wounds or generate the liquidity that they were desperate for.  The Obama administration purposely decided to leave the banks alone in 2009, so that they could go along their merry ways.  The administration wanted the banks to use the TARP monies to generate profits and wanted the shares of the banks to recover so that they could raise additional capital by issuing and selling new shares to build up their coffers. 

In hindsight, I now believe that the strategy mapped out by Volcker and the Obama administration was brilliant.  They pulled it off with perfection.  The limitations on executive compensation, which were put in place for those banks who owed the U.S. government repayment for TARP was shrewd.  If those restrictions had not been put in place I doubt that many of the banks would have voluntarily diluted their shareholders to pay the U.S. government back.  All of the big banks with the exception being Citigroup (NYSE:C) diluted their shareholders by raising additional capital to pay all of their TARP monies back.  They had no choice but to pay off the TARP otherwise they could not continue to pay the exorbitant be allowed to pay the exorbitant bonuses that their executives had become accustomed to.  Even with the significant dilution the shares of financial companies were among the top performers in the stock market during 2009.  Finally, the bank stocks led the entire stock market to one of its best performances ever and the major indices such as the S&P 500 and Dow Jones 30 Industrials right back to the levels that they were at in October of 2008.

There is no doubt in my mind that if the banking regulatory reform proposed by the Obama Administration had been announced and enacted during the first half of 2009, the following would have happened:

• Share prices of many financial companies would not have recovered.

• The economy would not have stabilized.  It still has not yet recovered.

• The major indices including the S&P 500 and Dow 30 would not have had the significant gains that they had.

The big question now is what will be the consequences for the stock market and economy that stem from the enacting of the financial regulatory reforms proposed by President Obama?    

The recent announcement by the Obama administration that they were going to cap the size at which a bank can get to (10% of all U.S. deposits) and eliminate the ability for banks to trade for their own accounts is a major game changer.  If the changes occur as proposed they will have a significant long term negative impact on the share prices of financials which represent a significant portion of the U.S.’ equity markets.  Thus, with the news I expect that the major indices are now much more susceptible to a significant increase in downside volatility and a severe downturn than they were only a week ago.  All bets are now off.  Investors and traders should expect the dramatic to now happen until the major indices can establish a secure footing.  The reasons why are as follows:

• New Legislation will Pass – The odds are high that the U.S. Congress will pass the legislation or the restrictions that the Obama Administration is requesting to regulate the banks.  This is because Main Street and the U.S. electorate is fully behind the placing of major restrictions on banks. 

• Contraction in Share prices – There is no doubt that the share price to fundamental multiples such as the Price Earnings (PE) Multiple for all financials including the large and small ones are going to contract.  The question will be what is the degree of volatility, in which the share price declines will occur.  The reason why is because there will be a limit or ceiling to how much a bank can earn. Without having the ability for the underlying business to grow its shares are confined to trade based on the dividend yield that they can pay.  There can be no share price multiple expansion, only contraction if a business can not grow.  The only other industry that is under such growth restrictions is the Regulated Utility industry.  The shares of regulated utility companies trade at the lowest multiples in the stock market.  Investors purchase them for income and not capital appreciation.  For a simple understanding of this let me explain.  Under the new proposal its likely that Bank of America, Wells Fargo, Citigroup and J.P. Morgan will not be able to grow because each of them either have or are close to accounting for about 10% of all deposits in the U.S. 

Why would any true investor want to own the shares of these banks for any other reason than receiving dividend payments?  On the other hand lets take a look at the U.S. shipping industry.  Its dominated by UPS and Federal Express who each account for much more than 10% of the total shipping market in the US.  Neither of them are restricted by regulators from growing and increasing their share of the shipping market.  Over the last 20 years Fedex (NYSE:FDX) shares have increased by six fold while the shares of Consolidated Edison (NYSE:ED), which is one of the U.S.’s biggest regulated utility companies have increased by 50%.  Competing with the regulated utilities for income oriented investors will be a great dilemma for the newly regulated banks as they currently have an aggregated market cap of $1.62 Trillion, which is 60% greater than the $1.0 Trillion aggregated market cap of the regulated utilities.  Before the banks can even begin to compete with the utilities for the favor of income oriented investors they must first get their loan losses under control so that they can pay a dividend and secondly their share prices will have to adjust downward so that the yield that they pay will be based on their dividend yield will be competitive with the yields that investors can get on utility company shares.   The big question is where are those dividend seeking investors going to come from which will be required to soak up the shares of the newly regulated and non-growth banks.  The bottom line is that the transition of the banks away from growth oriented investors to income oriented ones will cause them heartburn or contracting share prices for years to come.        

• Local and Regional banks will not escape – Small local and regional banks who will have the room to grow will not escape Obama’s wrath, which has been incurred by the national banks.  Over the previous century one of the central themes of capital accumulation, which was practiced throughout the US was the formation of banks, which were started and grown for the purpose of being acquired by bigger banks.  This was a low risk and high reward strategy, which was utilized by leading businessmen throughout thousands of U.S. communities.  The contraction of multiples and the focus on profit margins over deposit growth will put a damper on merger and acquisitions and the liquidity generated from them as well.

• Collateral Damage – The withdrawal of the banks from trading their own proprietary accounts to generate trading profits will result in a significant decrease in liquidity for all debt and equity securities.  The reduced liquidity will mean that trading firms and market makers with far less available capital will have to take more risk.  The decreases in liquidity will increase the risk and the volatility for all but the nimblest of investors.  Those who are not among them should expect a decline in all of their large and mid cap holdings, with the exception being those companies, which are categorized as “Emerging Growth”.

• Proprietary Trading – The banks are already putting out paraphernalia that investors should not be concerned because the profits they make from proprietary trading is insignificant.  That may be the case but its not the crucial issue for several reasons:  The bonuses that Goldman pays to its employees accounts for more than ten times Goldman’s proprietary trading profits.  With a significant decrease in amount of trading capital Goldman will have to lay off a significant number of its employees because it will no longer have the trading profits to support its overhead.   This will be very bad for the economies of New York and the States that surround it.  Because employee compensation for Goldman was almost 50% of the total revenue it generated in 2008, its revenue would decline by about 50% if it were restricted from proprietary trading.  Finally, the capital that Goldman is utilizing for proprietary trading is also providing liquidity for investors over a broad range of securities markets.  Should Goldman and the other big banks significantly reduce the amount of dedicated capital for proprietary trading the liquidity of many securities markets will decline significantly.  The result will be a contraction of multiples and an increase in the price volatility of securities markets.

For the duration of our lifetimes the glory days for the banks and financials and their shareholders are over.  With the new regulations financial companies and the performance of their shares are destined to go back to the days that they were considered as stodgy investments.  That was the sixty-six year period between 1933 and 1999, which began the last time that the banks had to undergo regulatory reform due to their risky practices, which led to the Great Depression which started in 1929.  

Now that Obama and his administration are now taking drastic action to institute regulatory reform for the banks and financial companies, I expect that the stock market pick up where it left off in early 2009.  I expect it to resume the downward course that it was on one year ago in January.  On January 23, 2009, the S&P 500 index closed at 831.95 and the Dow 30 Industrials closed at 8077.00.  Both indices were 20% lower than their present levels.  Those investors who missed out on getting out of the market in October of 2008 should take advantage of this opportunity to do so with the Dow 30 above 10,000 and the S&P 500 above 1000.