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Will Financials Take the Market Lower?

Will Financial Stocks Take the Market Lower?
By Ron DeLegge, Editor
September 1, 2009

SAN DIEGO (ETFguide.com) – The broader stock market has found (at least for the moment) a peculiar ally: The beleaguered financial sector.

While financial stocks lost more than half their value last year, so far in 2009, they are among the S&P’s top performing industry sectors. Financial stocks (NYSEArca: XLF) are already ahead by 17.4% through the August 31st market close.

But can it last?

Dissecting Financials
The financial sector consists of publicly traded asset managers, investment brokers, banks, insurance companies and specialty finance corporations. Currently there are 79 financial stocks within the S&P 500 and they represent around 15% the indexes’ sector representation.

Top holdings within the financial ETF (XLF) are JP Morgan Chase, Bank of America and Wells Fargo. Since bottoming in March, financial shares have doubled in value. Even the beleaguered Citigroup climbed almost 60% in value during the month of August alone!

Financial sub-sector ETFs like the SPDR KBW Bank ETF (NYSEArca: KBE) and the SPDR KBW Insurance ETF (NYSEArca: KIE) have climbed 8.65% and 28.41% respectively year-to-date.

Storm Clouds Linger
Optimism in the financial sector is being challenged by new and unwelcome economic realities. Trouble in the banking sector has been a drain not just on the financial sector, but on the Federal Deposit Insurance Corp. (FDIC).

At the end of June, the FDIC had just over $10 billion to cover bank deposits, depleting its insurance fund by around 80% from last year. Put another way, the federal agency which provides the very insurance on bank deposits of $250,000 per depositor bank itself is close to being tapped out. Meanwhile, the number of troubled banks at the risk of insolvency is now more than 400. Will the FDIC become the next bailout kid?

Another looming issue facing the financial sector is the troubled commercial real estate market, which could very well become the next phase of the financial crisis that began with residential real estate. According to Realpoint, LLC default rates on commercial mortgage backed securities (CMBS) have been soaring. For now, rising vacancy rates continue to reduce cash flow and hammer property values. According to a Wall Street Journal report, banks now hold $1.7 trillion in commercial mortgages and construction loans. Many of these loans are just beginning to sour.

The Uphill Road of Reality
Having risen so convincingly since March, many Wall Street analysts now believe the worst is over. Some leading economists have become so emboldened as to predict the worst economic recession of our generation has already ended. Isn’t it odd how the same ones who say the worst is now over never saw the worst coming?  

Many economic indicators, in fact, do not indicate the national or global economy is yet out of the woods. These points were addressed in a recent article titled, “Is this rally out of sync with the economy?” Various unresolved factors still pose a serious threat to any sustainable economic recovery or stock market gains.

Conclusion
The discrepancy between real economic activity and the stock market’s five month gains is striking. Certain corporations have posted “good earnings” not because of solid market fundamentals, but out of aggressive cost cutting.

According to AltaVista Independent Research, financial stocks are the second most overvalued S&P sector and they carry a P/E ratio of 22.4 compared to just 16.5 for the S&P 500 (NYSEArca: SPY). Can the current valuation of financial stocks justify their lofty values? And can earnings and profits justify today’s stock prices?

Time will tell.

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