Kass Katch: Buy the Financials. Yes, Buy

This blog post originally appeared on RealMoney Silver on Jan. 14 at 8:05 a.m. EST.

It's been a long, hard road for financial stocks, and no one's been more critical of the group than I have. However, could they be on the mend -- and what's a way to play it?

The Financial Select Sector SPDR(XLF Quote) is a broadly diversified and liquid exchange-traded fund that has exposure to the leading companies in the financial sector.

Top 10 Holdings of the XLF (listed alphabetically):

• American Express (AXP Quote) -- 2.89%
• American International Group (AIG Quote) -- 6.17%
• Bank of America (BAC Quote) -- 8.47%
• Citigroup (C Quote) -- 6.86%
• Goldman Sachs (GS Quote) -- 3.81%
• JPMorgan Chase (JPM Quote) -- 6.39%
• Morgan Stanley (MS Quote) -- 2.30%
• U.S. Bancorp (USB Quote) -- 2.37%
• Wachovia (WB Quote) -- 3.39%
• Wells Fargo (WFC Quote) -- 4.49%

XLF Statistics:

• Average price/earnings ratio = 11.9 times
• Average price/book ratio = 1.46 times
• Average price/revenue ratio = 1.91 times
• Average price/cash flow ratio = 13.7 times

On Thursday and Friday, I covered all of my longstanding shorts in the financial sector. That includes positions in brokerages, banks, mortgage originators and mortgage insurers.

Last week, I described the most difficult issue that investors face today: To what degree have market prices discounted the emerging fundamental weakness?

We seem to be moving in the right direction. For the first time (coincident with the recent drop in share prices), a discounted cash-flow model today, based on my consistently below-consensus 2008 S&P 500 profit forecast of $80 and other reasonable assumptions, produces an undervalued market reading.

1. 2008 to 2010 S&P 500 EPS (estimated) of $80, $85 and $90.
2. Long-term earnings growth of 6.5% for seven years, 10-year transition to maturity growth rate of 5%, equating to a risk premium of 3.5%.
3. 10-year bond yield of 3.8%.
4. Payout at maturity of 45%.

Just as interesting, another approach, using 2008 dividends of $29.50 less the corporate bond rate, produces a spread about equal to the average at previous bear-market bottoms.

Anecdotally, even the formerly "Liebnetzian" mood from Larry Kudlow's band of merry men, to judge by when I appeared on Friday night's "Kudlow & Company," is growing more cautious. And so too is the formidable Ben Stein backing off of his previous and unadulterated optimism.

Nowhere is the tug of war between fundamental deterioration and the near universal and elevated negativity sentiment as acute as in the financial sector.

This is not surprising as the financials stand at the epicenter of all that is bad with the world's economies. That includes the excessive use of leverage, vulnerability to a likely reversal in credit-loss experience -- see American Express and Capital One (COF Quote) -- and exposure to a domestic recession, an extended consumer and to a protracted downturn in housing.

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