Financial sector stocks presently resemble insects in the way they are undergoing progressive metamorphoses into ever new shapes and forms.

During a comparatively compressed period of time, just two years or so since the global credit crisis set in, banks and other financial sector companies have found themselves ushered into a whole new environment of reregulation that will change the game for investors in their shares.

The global credit crisis marked the end of the Great Moderation era.

During the Great Moderation – the 25 years or so of apparently perennial steady GDP growth coupled with low inflation and rising asset prices, particularly for residential property – stocks in banks and related financial sector industries flourished.

So well did their share prices do that financial sector stocks came to dominate the upper end of the sharemarket indices they were included in thanks to their overwhelming market capitalisation.

Investors – whether direct stockpickers or buyers of portfolios others assembled via managed funds – had heavy exposure to financial sector stocks as a consequence.

Then along came the global credit crisis, starting in August 2007 and peaking in its intensity of fear in the aftermath of September 2008, when major Wall Street investment bank Lehman Brothers went bust and AIG, the world’s biggest insurer, needed a US government bailout to avoid the same fate.

Suddenly financial sector stocks didn’t look too hot any more, and indeed there was a shareholder stampede to the exits due to collapse of trust in any listed financial institutions that could possibly be at risk.

Resulting radical deflation of financial sector share values meant many banks and their like mutated from the whales to the minnows of the sharemarket capitalisation indices that included them.

Several price support actions happened during the financial sector stock meltdown.

First, short-selling of these stocks was banned by many securities market regulators.

Short-selling involves borrowing shares and selling them on the market, then waiting for their price to fall in order to buy them back again at lower prices, booking a profit, and returning them to their lender.

It was thought by securities market regulators that their financial stock short-selling bans were clever ways to decelerate price fall pressure, but the opposite happened as investors took fright at the special exception made for the financial sector and got rid of its shares as fast as they could.

Most regulators came to their senses fairly quickly (a notable exception was the ASX) and reversed the bans.

Second, government authorities started buying preference shares in financial sector companies affected by solvency issues and also purchased their debt securities outright.

These actions no doubt saved many financial firms from going bust, but also diluted existing shareholdings and left governments in charge of banks and the like.

While the companies concerned were rescued, the price was even further loss of confidence by their shareholders, many of whom bailed out.

Third, the US Financial Accounting Standards Board (FASB) introduced new rules for valuing delinquent debt securities that allowed American banks to opt out of catastrophic mark-to-market valuations for such junk.

The combination of the second and third initiatives above enabled many financial sector companies to escape the gallows and their share prices rebounded in response, starting in March 2009.

In particular the largesse of FASB – winked at by US authorities – permitted many financial companies to combine cost cutting with government infusions of capital and accounting sleight-of-hand to avoid insolvency and report profits above market expectations, boosting their share prices.

A rash of new share and bond issues by these companies at cheap prices saw them recapitalised to the point where many have been frantically paying off their government loans and preference share obligations, which helps explain why many banks aren’t keen on lending to their household and commercial client bases instead.

All up, the resurgence of sharemarkets around the world has had much to do with financial sector company shares reflating, which gives rise to the question of whether we can expect a return to business as usual, with financial sector shares making up one of the largest parts of many investment portfolios.

This question takes us to the present outlook for financial stocks as investments within the context of financial sector reregulation.

The principal factor which will influence future returns from financial stock investments is the degree to which any companies concerned will be regulated under the new risk-averse environment that permits government authorities – especially those with financial markets supervisory roles – to stick their oar in.

The further the oar is stuck in, the lower the returns from investment from financial sector stocks.

The most heavily regulated financial sector companies under the new state interventionist regime will see their share price performance join company with other utility stocks.

Utility companies in many markets are subject to heavy-handed regulatory controls at multiple levels of corporate activity.

US examples are the likes of power and water companies, which are regulated as to prices, profits, practices and customers, and cannot even scratch their backsides without some regulatory tin Hitler coming over to check out the legitimacy of the itch.

As a consequence of this interventionism, the stocks of US utility companies behave like bonds because the opportunities for business growth and profit increase are low, and accordingly their profits sourced from a capped marketplace are paid out as steady dividends just as bonds pay out fixed interest returns.

Here in New Zealand somewhat similar examples would be telcos and power companies, because successive governments have notched up their controls over what these outfits can charge and by extension what profits they can make.

Thus Telecom New Zealand is now a utility stock, as US stockmarket investors would interpret its situation, and in train with that its shares should trade as if they were unsecured bonds.

The equity dimension of Telecom New Zealand share price performance should diminish, while bond-like characteristics should prevail.

Pretty much the same applies to many financial sector stocks – reregulation is going to turn their issuing companies into utilities whose equities trade as bond look-alikes.

The upshot is that many investors will be decategorising their financial sector stock exposures as growth opportunities and instead recategorising them as quasi-fixed interest.

One implication would be that passive sharemarket index tracker funds that feature substantial exposure to financial sector stocks will fair poorly versus active funds that deselect against newly reregulated financial companies, provided the active fund managers don’t chew up all the gains in fees.