Biting the Bullet on Financial Stocks

Here's why S&P has downgraded its recommendations on the sectorand several big names in the group

Until recently, Standard & Poor's Equity Strategy Group had maintained a marketweight recommendation on the Financials sector, as we had believed that most of the negative news surrounding the mortgage market problems, as well as the recent weakness in near-term earnings, was already factored into financial equity prices. Obviously, we were wrong.

So now the question: Is it too late to underweight? We think not. On Nov. 2, S&P lowered its recommendation on the sector to underweight from marketweight.

At the beginning of this year, S&P equity analysts were projecting a 4.2% increase in third-quarter operating earnings for the S&P 500 Financials sector. Due to unexpected writedowns, we now see earnings declining 25.7% for the quarter. For the full year, we thought we would see a 6.4% increase in sector earnings. Now it looks as if we'll get a decline of close to 1%. We are currently forecasting a 10% increase in operating earnings for the S&P 500 Financials sector in 2008, vs. the expected 14% advance for the S&P 500-stock index. We now believe these expected results may be optimistic.

Even if they aren't, the Financials sector is still trading at a premium relative valuation to the S&P 500—despite the sector's recent decline— to its average over the past 10 years (which is as far back as S&P has data on sector earnings). Since 1995, the S&P 500 Financials Index has traded at a 29% discount to the S&P 500, based on trailing operating earnings. Looking to yearend 2008 estimates, the sector recently traded at a 14% discount to the market, or about 20% above its longer-term norm.

Take a look at the accompanying chart. On a rolling 12-month relative price comparison, the S&P 500 Financials sector is low, having fallen 9.5% in the past 12 months to the S&P 500's advance of 9.5%. This disparity places the sector's 12-month relative strength reading more than one standard deviation below its average since the early 1970s. While low, this sector has touched and surpassed two standard deviations below its mean three prior times, most notably in the midst of the Savings & Loan crisis and the junk-bond market meltdown in the early 1990s, which we believe bear similarities to the current mortgage meltdown and credit crisis.

Finally, as a result of recent downgrades by S&P equity analysts, financial stocks now represent less than 15% of S&P's 5-Stars, or Strong Buy list. Stars rankings on a number of well-known names were lowered on Nov. 2. We've highlighted three moves below:

Citigroup: Downgraded to 3 Stars (Hold) from 5 Stars

Analyst Frank Braden notes that while S&P believes it is unlikely that Citi (C; $38.51) will need to cut its dividend, the suspension of share buybacks and possible asset sales may be necessary to boost capital levels, which may preclude Citi from taking advantage of market opportunities in the near term. Braden cut his 2007 and 2008 earnings per share estimates to $3.80 and $4.50, from $3.82 and $4.89. He also lowered his 12-month target price to $45 from $59.

Goldman Sachs: Downgraded to 4 Stars (Buy) from 5 Stars

Analyst Matthew Albrecht reduced his recommendation on Goldman (GS; $230.01) on the stock's valuation. Although he continues to believe Goldman has shown the strongest risk management controls and is best positioned to weather the current storm, Albrecht see less upside potential after a recent upward move in the stock. He kept his 12-month target price at $250.

Wachovia: Downgraded to 4 Stars from 5 Stars

Due to S&P's expectation of further writedowns at Wachovia's (WB; $43.54) corporate and investment bank and a continuing decline in the housing market, Braden cut his 2007 and 2008 EPS estimates to $4.41 and $4.77, from $4.93 and $5.39. He is also lowering S&P's 12-month target price to $52 from $62. While he believes Wachovia's option-ARM portfolio is more conservative than those of its peers, Braden expects that its large exposure and the longevity of the housing downturn in California will keep pressuring earnings as provisions for loan losses continue to grow.

In summary: Because of questionable earnings-growth prospects, high relative valuations, historical precedent for even weaker relative price performance, and recent equity analyst Stars downgrades, we believe it is not too late to benefit from an underweighting of the S&P 500 Financials sector.

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