Stocks Lose Financial Footing

As evidence that financials aren't cheap, he says, there hasn't been a pick-p in M&A activity within the overall sector this year. In 1995, 20% of all M&A activity in dollar terms came from the financial sector. So far this year, the sector's contribution is only 14.5%.

Levkovich says the recent run-up in financials' stock prices warrants a near-term pullback, but he is less bearish on the sector next year.

If the yields of 10-year Treasuries do indeed go down next year, as Citigroup's economists expect, that should work in favor of the banks especially. But Levkovich keeps a neutral (and market weight) stance on the banks given their current valuations and recent upward earnings revisions, which leave these stocks vulnerable to bad news.

He does have an overweight stance in diversified financials, though, which include investment banks, brokers and asset managers, including Merrill Lynch (MER), Goldman Sachs (GS) and Schwab (SCH). Although, like banks, near-term weakness can be expected through the first quarter of 2006, this would be a good time to buy, he says.

Levkovich expects the overall stock market to rally in 2006 as the market starts anticipating the potential for Fed easing later in the year. This should boost equity commissions, improve underwriting margins and fee revenues.

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