Stovall: Financials Find a Friend in the Feds

S&P boosts its recommendation on financial-sector stocks to market-weight in view of the government's plan to help banks deal with troubled assets

With Catherine Seifert, Stuart Plesser, and Matthew Albrecht

On Sept. 19, Standard & Poor's Equity Strategy Group upgraded the S&P 500 Financials sector to market-weight from under-weight. The U.S. equity market is likely to continue to respond favorably, at least in the near term, to Treasury Secretary Henry Paulson's proposal to create a Federal agency similar to the Resolution Trust Corp. (RTC), which would allow troubled assets to be moved from the balance sheets of financial companies into this new institution.

Many issues remain unanswered, however, such as the specific assets to be acquired, at what price, and to which firms this offer is available.

Additional positives from the government plan, at least in the short term, include the reactivation of the short rule on financial issues and the proposal to insure money market assets.

Besides the outstanding question surrounding the proposed actions of the new federal agency, investors are wondering how long and how high the market and sector will advance. This is hard to quantify, in our opinion. The S&P 500 surged 50 points on Sept. 18, after slumping to 1156 on the 17th, perhaps the low of this bear market. The S&P 500 peaked on Oct. 9, 2007, and declined 26% through mid-September.

Some Relief

Many investors purchased equities at much higher prices, and they may simply use the rally to unload these holdings once they get back to break-even. Also, if history is any guide (it's never gospel), the upcoming rally may run out of steam should the U.S. economy experience a deeper-than-expected recession. We believe the recent government action has helped resolve the current crisis of confidence but has not relieved consumers of historic debt burdens and has not erased the expected decline projected by S&P Economics for U.S. gross domestic product for the 2008 fourth quarter and 2009 first quarter.

To refresh memories, the RTC was created as a result of the Financial Institutions Reform Recovery & Enforcement Act of 1989 (FIRREA), which was signed into law on Aug. 9, 1989. As seen in the accompanying chart, in the period shortly after the creation of the RTC that August, the S&P Financials sector advanced, as did the overall equity market in the wake of the 1987 crash. Heading into the 1990s recession and accompanying 20% bear market, the S&P Financials quickly gave up their market leadership.

Obviously, today's crisis differs greatly in scope from the savings and loan crisis of the late 1980s through early 1990s. In addition, the S&P 500 Financials sector, at 14.3% of the S&P 500 index today, has a much greater influence on the S&P 500 than it did in 1989, when it represented 8.8%.

Finally, because of the introduction of the Internet, financial TV, computerized trading, hedge funds, etc., we think these factors contribute to today's much more rapid and volatile market movements. But sector rotation requires playing the odds frequently. From the March 2007 peak until the mid-July low, the S&P 500 Financials sector index declined 54%. During the most recent equity market slump, this sector index also fell but remained above its mid-July low.

As a result of the Federal government's efforts to halt this runaway train, combined with recent sector price action, we believe the worst for this sector may be over.

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