S&P Boosts Its View on Financial Stocks

The upgrade of the sector to market weight is based on improving fundamental and technical outlooks, with nine stocks earning the top rating

On Apr. 2, Standard & Poor's Equity Strategy Group upgraded its recommended weighting of the Financials sector to market weight, from underweight, based on what we view as an improving technical and fundamental outlook. Year to date through Apr. 3, the S&P Financials index, which represented 17.4% of the S&P 500-stock index, was down 7.7%, compared with a 6.5% decline for the S&P 500.

There are 20 subindustry indexes in this sector, with Other Diversified Financial Services being the largest at 22% of the sector's market value.

S&P equity analysts have a neutral fundamental outlook on the Financials sector. According to Cathy Seifert, who heads S&P's Financial Services Group, although S&P analysts believe that securities writedowns will continue in the first half of the year, S&P believes that for most companies in the sector, the extent of the writedowns are already reflected in current stock valuations. In addition, S&P thinks the Federal Reserve will continue to support the banking sector through lower interest rates, creative use of the discount window, and the purchase of illiquid securities. "We also believe that additional legislative action, if needed, will act to cauterize the sector from the further spread of credit woes," she wrote in a recent note.

The sector now trades at a price-to-earnings ratio on estimated 2008 earnings per share of 12.4 times, vs. 14.2 times for the broader market. Its p-e to projected five-year EPS growth rate (PEG) of 1.1 times is in line with the market's PEG of 1.1 times. The sector's market-weighted S&P STARS average of 3.4 (out of 5) is below the average of 3.7 for the S&P 500.

Bottoming Out

As seen in the accompanying chart, the trailing 52-week relative strength for the S&P 1500 Financials index recently fell more than two standard deviations below its mean relative strength since 1990, implying (but not guaranteeing) that the group may now represent a good long-term investment opportunity. It also appears as if the relative strength has bottomed. As a reminder, the jagged blue line represents the sector index's rolling 52-week price performance compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two blue and green bands indicate one and two standard deviations above and below the index's long-term relative strength.

S&P's Chief Technical Strategist, Mark Arbeter, recently raised his technical opinion on Financials to neutral with a negative bias, from bearish. Arbeter points out that the S&P Financials index dropped to a new low in March, falling below support from the lows in January. He says it is possible that the sector is tracing out an inverse head-and-shoulders bottom, but it is too early to tell.

The recent rally has run right into numerous pieces of resistance in the 360 to 370 zone. While the 17-week exponential average remains below the 43-week exponential average, a bearish sign, the 17-week average is starting to flatten out, a potentially bullish indication that downward momentum is starting to wane.

The index's weekly moving average convergence/divergence, or MACD, indicator is starting to curl higher, also a good sign, by Arbeter's analysis. He says the index's relative strength compared with the S&P 500 remains in a downtrend, but may be trying to base.

So there you have it. From both a fundamental and technical perspective, we believe that the worst is likely over for the S&P Financials sector. S&P equity analysts recommend that investors focus primarily on those names within the insurance, banking, and REIT industries whose shares have been unduly penalized by weakness in the sector.

There are currently nine 5-STARS recommendations: AFLAC (AFL), Allied Irish Banks (AIB), Banco Santander (STD), Chubb (CB), Cullen Frost Bankers (CFR), Hartford Financial Services (HIG), Lloyds TSB Group (LYG), MetLife (MET), and Simon Property Group (SPG).

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of 5 (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), along with a stock that has the highest S&P STARS ranking (tie goes to the issue with the largest market value).

Subindustry Company Ticker S&P STARS Rank Price (4/3/08)
Coal & Consumable Fuels Peabody Energy BTU 3 $57
Computer Hardware IBM IBM 5 $116
Construction & Engineering Fluor FLR 4 $153
Construction & Farm Machinery Manitowoc MTW 5 $45
Diversified Metals & Mining Freeport-McMoRan Copper FCX 3 $107
Fertilizers & Agr. Chem. Monsanto MON 3 $119
Industrial Gases Air Products APD 3 $97
Integrated Oil & Gas Exxon Mobil XOM 5 $89
Internet Retail Amazon.com AMZN 3 $75
Marine Kirby KEX 4 $56
Oil & Gas Drilling Noble Corp. NE 5 $53
Oil & Gas Equip. & Svcs. Baker Hughes BHI 5 $72
Oil & Gas Expl. & Prod. Swift Energy SFY 5 $46
Railroads CSX CSX 4 $58

Source: Standard & Poor's Equity Research

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