Will Investors Flock Back to Financials?

Rally in Long-Maligned Sector May Not Be Sustainable, Some Experts Say

If you have any money in financial stocks, last week was a dizzying one for you. And this week might not be any better, analysts and investment strategists said.

In just a matter of days, financial stocks plunged after IndyMac Bancorp collapsed in the third-largest bank failure in U.S. history, then surged after better-than-expected earnings reports from lending giants Wells Fargo and Citigroup.

For months, the financial sector has been blamed for dragging down the entire stock market. But by the end of last week, it was propping up the market, helping the Dow Jones industrial average end the week with a 3.57 percent gain. It was technology companies that underwhelmed analysts by week's end, with Google and Microsoft releasing disappointing earnings reports.

"We now have stark comparisons: Wells Fargo on one side, IndyMac on the other side," said David Kotok, chief investment officer for Cumberland Advisors in Vineland, N.J. "The conclusion is, they're not all bad. Some are good."

Indeed, several banks ended the week on a high note. Although it reported a $2.5 billion second-quarter loss due to write-downs, Citigroup came out a winner because analysts had expected worse. Wells Fargo had an even better week, logging a second-quarter profit of $1.75 billion, or about 53 cents a share, and raising its dividend. J.P. Morgan Chase also exceeded expectations. Even a dismal earnings report from Merrill Lynch could not temper the optimism.

But is such a rally sustainable? Is it time to buy shares of financials? Are we headed back to bull-market territory?

Not so fast, industry analysts said. "It's definitely too premature to wave a victory flag and go running back to financials," said Wendell Perkins, chief investment officer of Optique Capital in Milwaukee.

Although some analysts argue that last week was a sign that financials have reached bottom and are headed to recovery, others say the rally might not last because it was artificial, caused by the actions of short sellers and the federal government.

Short sellers sell stocks they borrow from brokers. Eventually, they have to buy back shares to replace what they borrowed. They make money if they buy them back at a lower price but lose if they have to buy high. Last week's slump in financials provided them the perfect buyback opportunity.

"There have been an awful lot of people shorting financial stocks," said Ralph Parks, chief executive and president of Ralph Parks Investment Group in Pittsford, N.Y. "It's not people that are investing in it. It's people who are covering their shorts, meaning they have to buy back their stocks."

At the same time, the Federal Reserve reiterated its support of financial companies by proposing a plan to bolster mortgage giants Fannie Mae and Freddie Mac. Meanwhile, the Securities and Exchange Commission stepped in to reduce the volatility of financial stock prices by prohibiting a practice known as naked short-selling, in which investors effectively sell shares they never borrowed.

"I think this is a Washington-created reversal in financial stocks," said Richard B. Hoey, chief economist of the Bank of New York Mellon.

The drop in oil prices has also provided financial stocks a lift. One reason, analysts said, is that higher oil prices weigh on stocks by increasing many companies' operating costs. They also put more pressure on the consumer and the economy, increasing the risk of loan losses, said Bill Stone, chief investment strategist for PNC Wealth Management.

The sector's somewhat positive earnings reports were a major reason for the rally. So it's no wonder that analysts are anxiously awaiting reports from major financials such as Bank of America, Wachovia and SunTrust scheduled for this week.

"If you look at the banks that have reported thus far, . . . most are the ones in better condition," Perkins said. "Next week is really when we begin to see some of the weaker banks reporting. Maybe it's premature to be looking at this and making any conclusions."

In the meantime, investment strategists recommend remaining cautious and not rushing to pile financials into your portfolio. "This market is still very weak, meaning there are more people selling stocks than buying stocks," Parks said.

Until the housing market turns around and inflation eases, stocks will probably continue their unpredictability, analysts and strategists said. If you're already invested in financials that are performing poorly, it would probably be best to stay put and wait for a rebound, they said. But if you're really uncomfortable with them, you could switch your money to a stronger company, Stone said. "It might behoove you to upgrade it."

Whatever you do, make sure you have exposure to the major markets and different sectors. You should also have some large-capitalization stocks, some small-capitalization stocks, some commodities, some utilities and so on, said Randy Bateman, chief investment officer of Huntington Asset Advisors in Columbus, Ohio.