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Looking to take advantage of the big drops in the major broker-dealers? They sure look cheap, huh? If you take an average of Goldman (NYSE:GS), Lehman (LEH), Merrill Lynch (MER) and Morgan Stanley (NYSE:MS) (the four largest domestic B/Ds), you end up with a PE of just 9X forward 1-year EPS, a P/B of only 2 and a year-to-date price decline of 16% (through 8/2). That doesn’t even include #5, Bear, Stearns (NYSE:BSC), which is down 29% as of the close last night and trades at 7.5X earnings and 1.3X BV. Cheap, right? Yes, just like the home builders were last year.

While it might be tempting to step in and snap up these on-sale companies with their significant underperformance and seemingly low valuation, one would be making a very serious mistake in my opinion. I view this weakness as perfectly rational, and I expect that we will learn that the earnings won’t be met and the book value is overstated. Besides, as you can see in the chart below, they can get a lot cheaper during times of crisis.

We are in a crisis. Credit standards are tightening rapidly, spreads are widening and risk-takers (hedge funds all over the world) are seeking liquidity. This is an environment that should lead to financial asset write-downs and lower origination fees for the investment banks.

This is no time to play with fire in my opinion. It is in the interests and hopes of many people to state that what is going on is limited – keep that in mind when you hear the rosy prognostications coming out of fund managers (they don’t want you to pull your money). The truth, though, is that the supposedly contained sub-prime problem became a sub-prime crisis, which became a mortgage problem, which is becoming a mortgage crisis, which is impacting the LBO machine and creating spillover into all of the so-called diversified asset markets. These things take a while to play out.

Ultimately, this will lead to a consumer recession (two quarters of negative GDP component growth). Clearly, the risk is that the overall economy contracts, though the strength of overseas markets and government spending in an election year could result in just very slow growth. Many think that Bernanke & the gang will rescue things by easing. I would argue that this will not only destroy the dollar but also be ineffective. Watch for the term “pushing on a string” to become very popular amongst columnists if this scenario unfolds.

I have included the following chart for just MER, though it is quite representative:

click to enlarge

Clearly, we are at a median P/B valuation over a very long time-frame. I know that many will say that book value is an artifact, but I would point out that at year-end, total equity supported assets of 20X. There is a lot of leverage employed here. In times of distress, the ratio has dropped below 1 (1987) and has approached 1 during the early 1990s and then again after the last Bear Market.

As far as P/E, the stock has traded at close to just 5X on several occasions. So, it isn’t far-fetched to give merit to the idea that MER may bottom close to 50. The other investment banks would appear to have similar potential downside.

Disclosure: No position in any of the stocks noted in this article

Source: I-Bank Stocks Are Falling Knives