Financial ETF Looks Good in the Bargain Bin

Unrelenting pessimism over fallout from the mess in subprime mortgages has weighed heavily on stocks in recent months, as investors fear that turbulence in the credit market will result in a full-blown credit crunch.

Particularly hard hit has been the financial sector: Shares of the Financial Sector SPDR (XLF Quote), though they have recovered some ground recently, are down about 5% year to date, making it the worst-performing S&P 500 sector by far.

But the focus on tidbits of negative news to the virtual exclusion of some very positive numbers for the sector as a whole may mean that investors have overreacted. Specifically, we see three factors that could make XLF a very attractive investment going forward:

1. Earnings estimates are rising, not falling.

Although debt-related problems are a hit to earnings in some places, they are not the only factor affecting earnings for XLF.

Strength in other areas, particularly in merger-and-acquisition activity (which brings tremendous fee income to Wall Street firms) has helped offset weakness in mortgage investments, while insurance firms have seen estimates rise as well.

As a result, overall estimates for XLF have risen steadily since the start of this year, even though the subprime issue has been conspicuous for quite some time.

Upward Trend in Earnings Estimates Estimates for XLF's full-year 2007 EPS; January=100

Source: AltaVista Independent Research

2. Actual results are strong.

With all but three S&P Financial firms having reported second-quarter results, sector earnings look like they will be up a 9.3% vs. the year-earlier period. But what's impressive is that expectations were for just 2.8% growth at the start of earnings season.

For example, although Bear Stearns' (BSC Quote) earnings report was a high-profile miss, Goldman Sachs (GS Quote)), JPMorgan Chase (JPM Quote) and most other Wall Street firms reported earnings that beat expectations.

That 6.5-percentage-point difference (between initial expectations for 2.8% growth and actual results of 9.3%) was the largest upside surprise of any sector, and it is by far the largest contributor to the "strength in S&P 500 earnings" we often read about in the press.

3. XLF is cheap.

If our analysis is correct that, on the whole, fundamentals in the sector are improving, not deteriorating, then XLF appears compellingly cheap. It currently trades at 11.6 times estimated 2007 EPS. Several of the largest, most stable constituents trade at single-digit price-to-earnings multiples, compared with 15.8 times for the S&P 500.

XLF also has a dividend yield of 2.8% which, if not something to write home about, still compares favorably with the paltry 1.8% yield on the S&P 500, and is close to the 3.0% yield of the Utilities Sector SPDR (XLU Quote).

XLF is Cheap Price to earnings ratios on estimated 2007 EPS.

Source: AltaVista Independent Research