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Don't Trust the Rally in Financials

http://www.fool.com/investing/general/2009/05/07/dont-trust-the-rally-in-financials.aspx

Ivan Martchev
May 7, 2009

It's been an interesting start to 2009. Four months into the year, we've seen a tale of two halves: The worst performers from the first two months of the year performed best in March and April.

The worst performers? Financials -- the stocks making the news -- continued their upward streak in April, appreciating 22.2%, but they remain down for the year. Financials and utilities remain the only double-digit decliners so far in 2009, which is not all that bad given the remarkable thud with which we started the year.

It is curious to note that things in April developed very similarly to the way they did in March:

Sector

April 2009

March 2009

First Quarter

Year-to-Date

2008

S&P 500

9.39%

8.54%

(11.67%)

(3.37%)

(38.49%)

Energy

4.81%

3.71%

(12.08%)

(7.85%)

(35.93%)

Materials

15.09%

14.93%

(2.82%)

11.85%

(47.05%)

Industrials

17.72%

9.16%

(21.77%)

(7.91%)

(41.52%)

Consumer Discretionary

18.54%

12.01%

(8.61%)

8.33%

(34.73%)

Consumer Staples

3.03%

3.55%

(11.31%)

(8.62%)

(17.66%)

Health Care

(0.89%)

6.33%

(8.52%)

(9.34%)

(24.48%)

Financials

22.17%

17.66%

(29.49%)

(13.86%)

(56.95%)

Information Technology

12.04%

12.08%

3.96%

16.48%

(43.68%)

Telecom

2.23%

5.91%

(8.47%)

(6.43%)

(33.62%)

Utilities

0.42%

2.09%

(11.86%)

(11.49%)

(31.55%)

Source: Standard & Poor's.

Provided that the S&P 500 had fallen more than 20% for the year in early March, finishing April down only 3.4% for the year is a heroic achievement. One big concern, though, is that this rally is led by the worst stocks -- a characteristic of bear market rallies, as I noted in March's performance wrap-up.

Still, even if this is a bear market rally, that does not mean you should necessarily fight it. As legendary trader Jesse Livermore said long ago, "There is only one side of the market, and it is not the bull side or the bear side, but the right side." With that in mind, let's try to make sense of the numbers.

False dawn for the banks?
While it appears that there's been a short squeeze in the financial sector, fundamentals drive the share price performance in the long term. Large short positions act like lighter fluid poured on wet wood. Yes, the fire burns spectacularly for a short while, but in the end, all you get is smoke.

Mike Mayo, the star banking analyst at Calyon Securities, believes that bank losses will be much larger than those during the Great Depression, leveling off between 3.5% and 5.5% of total loans made. 

During the Depression, the loan loss high-water mark hit 3.4%. We haven't reached that point yet, but as I recently read in a Goldman Sachs (NYSE: GS  ) research report, there's at least another year of climbing bank losses, given our current point in the recession, and the three-year cycles¬†such situations typically follow.

In that light, it is easy to see the recent sharp rise in bank stocks as a massive short squeeze. So to those chasing Citigroup (NYSE: C  ) and the like because they are "cheap," I say think twice, and instead study company fundamentals. You're better off sticking with well-run banks like JPMorgan (NYSE: JPM  ) and Wells Fargo (NYSE: WFC  ) .

Three out of 10
Three out of 10 sectors in the S&P 500 a