Can Financial Stocks Hold onto their Gains?
Ron DeLegge, Editor
September 25, 2009

SAN DIEGO (ETFguide.com) – The broader stock market has found (at least for the moment) an unorthodox friend: The beleaguered financial sector.

Even though financial stocks collectively lost more than half their value last year, so far in 2009, they are among the S&P 500’s top performing industry sectors. Financial stocks (NYSEArca: XLF) are already ahead by 17.7% year-to-date. But can it last?

Analyzing 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 6.64% and 27.93% respectively year-to-date. Over the same period, the S&P 500 (NYSEArca: SPY) has climbed by 16.4% and the Dow Jones Industrial Average (NYSEArca: DIA) by 10.8%.

Reality Bites!
A report just released yesterday, gives an inside view as to what’s really happening in the financial sector. According to the Shared National Credit Program (SNC) 2009 Review, U.S. banks and other financial institutions now face $53 billion in losses because of loose lending standards and weak economic conditions. It’s likely these latest findings will negatively impact third quarter earnings which are due in mid-October.

Established in 1977, the Shared National Credit Program’s purpose is to categorize and review large syndicated loans of at least $20 million financed by three or more banks.

As if the depressed market in residential real estate wasn’t enough, banks are now facing a depressed commercial real estate market. Defaults on commercial mortgage backed securities or CMBS has been rapidly rising. According to some estimates, banks now hold around $1.7 trillion in commercial mortgages and construction loans.

Optimism in the financial sector is being challenged by other unwelcome economic realities. Trouble in the banking sector has been a drain not just on the financial sector itself, 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?

The Steep Road to Recovery 
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 a paradox how some of the very same individuals and institutions who’ve now declared 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 positive economic activity and the resurrection in financial shares is striking. Certain companies 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. Can the currentvaluation of financial stocks justify today’s levels? And can earnings and profits justify their stock prices?

Time will tell.