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Are the Financials a Leading Indicator?

Posted by: Ben Steverman on May 14, 2009

I’ve been asking investing pros which industries serve as “economic weather vanes,” i.e. which parts of the stock market could be expected to rebound first in an economic recovery. Many of the answers, which ranged from truckers and retailers to tech firms and commodity producers, are discussed in this story.

But I didn’t have a chance to discuss one other sector that often leads the way when the economy turns: Financials. The financial sector certainly was an early indicator of the downturn in 2007 and 2008. Could it lead the way up?

Financial stocks have certainly rallied strongly in the last two months. And that does reflect some improvement in investor psychology, and it might even indicate the beginning of the end of the financial crisis.

But is that also an early sign of a strong economic recovery? Many experts doubt it.

“The biggest thing affecting the financial sector is the solvency issue,” First American Funds economist Keith Hembre told me. In other words, financial sector investors aren’t really watching the economy closely. They’re watching to make sure their equity investments aren’t wiped out, one way or another, by the horrendous balance sheets at many banks and insurance companies.

After the government’s “stress tests” of major banks and after many banks raised additional capital, those worries have receded somewhat. But major balance sheet problems remain, Michael Yoshikami, president and chief investment strategist at YCMNET Advisors told me. In particular, financial firms face large future losses from commercial real estate and credit card debt.

Of course, financial firms will still benefit from an economic rebound. A revival in the housing or labor markets will certainly ease concerns about many of the banks’ outstanding loans. The best economic indicators among financial stocks are those who have put their fiscal house in order, says Gary Wolfer, chief economist at Univest Wealth Management (UVSP).

He cites firms like Goldman Sachs (GS) and JPMorgan Chase (JPM), which, the government says, don’t need to raise more capital. In the event of an economic recovery, “they will be out of the gate first,” Wolfer says, “and in much better shape than those entities that have to raise additional capital.”

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Bloomberg Businessweek’s Ben Steverman focuses on the latest moves in financial markets and emerging trends in stocks, bonds, and funds, always with an eye toward giving readers a better understanding of the sometimes confusing and often chaotic world of money. Standard & Poor’s senior index analyst Howard Silverblatt will also provide his take on companies’ finances and the markets. Voted one of the “Top 100 Finance Blogs” in 2007.

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