ETF Talk: Is the Latest Financial Stock Rally Sustainable?

Recent rallies in the stock market and reports of profits at Citigroup and Bank of America during the first two months of the year are positive signs for financial stocks. However, it still may be premature to resume investing in the financial sector.

One reason is continuing risk that further economic fallout is ahead. The Congressional Budget Office (CBO) reported March 20 that deteriorating economic conditions will cause the federal deficit to soar past $1.8 trillion this year and leave the nation in a deeper financial hole than the White House had previously estimated. The nonpartisan CBO predicted that the administration’s agenda would produce deficits averaging nearly $1 trillion a year for the next decade — $2.3 trillion more than the president predicted when he proposed his spending plan in February. Folks, that’s a really big hole.

Bank stocks may have been even more volatile than the topsy-turvy market lately. The Financial Select Sector SPDR (XLF), an ETF that tracks the financial stocks in the S&P 500, rose 6.3 % Tuesday to recover from Monday’s drop of more than 8%. Since the rally started three weeks ago, beaten-down sectors such as oil are finally trending upward.

But let’s not get carried away by the modicum of good news.

The Federal Reserve’s March 18 announcement that it plans to buy more mortgage securities and $300 billion in longer-term Treasuries during the next six months might have been just a short-term catalyst for the market. The next piece of good news for banks could come this Thursday when bankers find out if the Financial Accounting Standards Board approves a move to give auditors more flexibility in valuing illiquid mortgage assets that may have long-term value and strong cash flow.

A few years ago, financial stocks such as Merrill Lynch, Goldman Sachs and JP Morgan, among others, rose strongly. Bankers and Wall Street traders in 2005-06 received big bonuses and global markets soared. Unfortunately, the subprime foundation of this boom began showing cracks in 2007. By 2008, the shaky structure collapsed and dragged the financial sector down with it.

The Financial Select SPDR (XLF) was one of the most beaten-down ETFs last year, when it lost 54.91%, compared to the 36.68% drop of the S&P SPDR (SPY). Investors who shorted financials through UltraShort Financials ProShares (SKF) would have gained 3.61% in 2008.

The real question is whether the latest rally is sustainable. The financial sector rally started when Citigroup and Bank of America reported profits for the first two months of 2009, with XLF rising 39% since March 6. It is important to remember that the rapid resurgence in financial sector stocks also stems from their extremely oversold condition last year. Citigroup and Bank of America each absorbed more than a 90% drop in share price in the last 52 weeks. Yesterday, Citigroup jumped 9.5% and Bank of America zoomed 13.1%.

Although I am trying to stay positive this year, I still see challenges for the financial sector. There still will be billions of dollars worth of toxic assets that will have to be written off, making year-end results for financials hard to forecast.

Personally, I am not sure about the longevity of the latest rally. While Citigroup and Bank of America notched unexpected profits for the first two months this year, I am not convinced both companies will be profitable at the end of the year. If you believe that we are simply in the midst of a bear market rally and that the financial sector is going to be rocked further by the credit crunch, shorting the index might be profitable. On the other hand, if you believe that this is the beginning of the rebound for the beaten-down financial sector, going long may let you pick up shares at very cheap prices.

If you want further guidance about which ETFs to trade and when, check out my ETF Trader service by clicking here. As always, I am pleased to answer any questions that you have about ETFs. To send your questions to me, simply click here. I will try to follow up in a future ETF Talk.