After the Bailout: Caution on Financial Stocks

S&P keeps its underweight rating on the sector, pending signs of recovery in financial firms' results and the housing market

By Sam Stovall From Standard & Poor's Equity Research

S&P's Equity Strategy Group, considering fundamental outlooks from our financial services equity analysts and evaluating technical considerations, recommends maintaining an underweighting toward the S&P 500 Financial Services sector. The news surrounding the takeover of Freddie Mac (FRE) and Fannie Mae (FNM) has given equity markets a near-term reason to be optimistic. But will this euphoria be short-lived? We think the chances are high that more data suggesting a bottoming in the housing market, combined with an easing of credit pressures, will be required before a change in recommended exposure is warranted.

Technically speaking, Mark Arbeter, S&P's chief technical strategist, is maintaining his negative opinion on the sector. To complete a major reversal formation for this sector, he would need to see the S&P 500 Financials index rally above the 320 level, which would take out two pieces of key resistance, in his opinion: the most recent high, as well as a bearish trendline drawn off the highs since October 2007. In addition, Arbeter would like to see the 17-week exponential moving average for the sector cross back above its 43-week exponential moving average. This moving average crossover system has been on a sell signal since August 2007.

The following are summarized comments from Catherine Seifert, S&P's Financial Services sector group head, and the financial services equity research analysts Matthew Albrecht, Brett Howlett, Robert McMillan, Erik Oja, Stuart Plesser, and Roy Sheppard.

A Catalyst for Upgrade?

The failures of Penn Central, Continental Illinois, E.F. Hutton, and Drexel Burnham historically rang the final lap bell in a market decline. Today, many on Wall Street believe that the elimination of the uncertainty toward government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac has presented a long-term catalyst toward the resolution of the mortgage-related crisis here in the U.S., and may present a reason to upgrade the investment outlook on the overall sector. We think the government backing will certainly encourage more investors to purchase the debt of these GSEs, which could translate to the potential lowering of the national 30-year mortgage rate from 6.3% by nearly one full percentage point.

Yet even if mortgage rates fall on this news, this alone won't automatically increase the amount of capital available by banks to lend. Rather, we think these institutions must first be concerned with unloading problem assets and reconfiguring their balance sheets. Until that happens, we don't see the mortgage spigot opening up. What's more, the rising unemployment rate will likely pressure other credit metrics, which will likely place additional pressure on banking institutions and further limit lending capabilities.

Crowded Concerns

We believe that while home prices should benefit from the takeover of Freddie and Fannie—since the mortgage rates will likely decline from today's level—capital constraints and stricter lending standards are apt to continue to constrain the amounts of loans available. Even though sequential declines in home prices, as calculated by the S&P/Case-Schiller Index, have slowed of late, we point out that there is still a more than 11 month supply of inventory, which is nearly twice the historical level. What's more, inventory levels do not include foreclosures, which have been rising at a steady pace. The takeover of Freddie and Fannie will not likely slow the rate of foreclosures, in our opinion.

Indeed, if a home price is lower than what the owner currently owes on the home, foreclosure will likely be a natural course. It is our opinion that in order for home inventory to be cleared to more normal levels, which is closer to six months, home prices will need to fall from current levels. This in turn would result in continued elevated provisions and securities write-downs.