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Tuesday, October 2, 2007

Financials rally while analysts cut earnings estimates

Can the rally in financial stocks last?

On Monday, Citigroup and UBS announced that their third quarter earnings would be significantly and negatively impacted by the turmoil in the credit and mortgage markets.

Nevertheless, the SPDR Select Sector Financials ETF (XLF) gained 1.89% on Monday and tacked on another 1.29% Tuesday. Similarly, the KBW Bank Index ETF (KBE) gained 1.77% on Monday and added 0.41% on Tuesday. It seems investment is rotating to the downtrodden financial sector in a big way.

Is this a short-term trading bounce or is the move for real?

In a contradiction of the move in the market, Merrill Lynch reduced 2007 earnings estimates for the following financial companies:






CompanyEstimate
Changed
From
Estimate
Changed
To
Comerica (CMA)4.604.55
Prudential Fincl (PRU)7.407.30
Bank of America (BAC)4.754.60
Wachovia Corp (WB)4.754.50
Citigroup (C)4.383.76


Note that all the institutions listed above are not only having 2007 estimates reduced but are also expected to end up with lower year-over-year earnings.

In a recent research note on Mid- and Small-cap banks by Merrill analysts Heather Wolf and L. Erika Penala, only one bank received a BUY rating -- Marshall & Ilsley (MI). The other 26 banks listed were rated either Neutral or Sell. Not a particularly enthusiastic endorsement of the sector.

My only conclusion is that the rally in financials will be short-lived. As XLF and KBE begin to move up closer to their downward-trending 200-day Moving Averages, look for these ETFs and their underlying stocks to run into some strong resistance.

Disclosure: author owns shares of C in a retirement fund

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