Can the

S&P 500

pick up the pace in the fourth quarter with financial stocks stuck in neutral?

With only a few weeks remaining in the third quarter and the finish line for 2005 now in sight, the S&P index is barely in positive territory, up just under 2% for the year. The fact it has any gains at all is mostly a testament to the strength of energy and utility stocks, which have carried more than their puny 12% combined weight in the index.

By removing energy and utility shares from the mix, the extent to which the remaining seven sectors that compose the S&P have been dead weight becomes uncomfortably clear. The most obvious anchor has been the 2.5% drop in financial stocks. These issues make up the biggest share of the index at just under 20%, and typically they are the engine behind any widespread rally.

When asked if financials will finally begin pull their own weight in the fourth quarter, most mutual fund managers reply, "It depends." That is, the question is whether you're talking about insurers, brokers or banks.

The Katrina Coin Flip

The Philadelphia KBW Insurance Index has largely rebounded from its post-Katrina lows, but the continuing uncertainty over the size and scope of the hurricane's damage is keeping many financial services fund managers from giving the sector the all-clear sign. Estimates for insured losses have risen in the last week to more than $35 billion, more than double the original post-Katrina assessment.

How much higher they can go seems like anybody's guess at this point. Major property and casualty insurers like

Allstate

(ALL) - Get Report

say it will take more than a month before they can get a handle on the total payout, mostly because of the challenges in getting claim adjusters on the scene.

"Insurance companies are in flux due to Katrina. It's something of a coin flip," says Doug Burtnick, senior portfolio manager for the

( GLFAX)Gartmore Global Financial fund.

The multibillion-dollar question facing insurers, and the funds that invest in them, is whether the hurricane damage in Louisiana will include flood damage. While it could be argued that the flood was caused by the hurricane, in some cases one could also argue that the flood damage was not directly caused by the hurricane.

If the ultimate decision to this chicken-and-egg question is that the hurricane came first and caused the flood, then insurance companies will be on the hook for a much bigger amount. But Charles Hebard, portfolio manager for the $181 million

(FSPCX) - Get Report

Fidelity Select Insurance fund, does not expect a decision anytime soon, considering the difficulties insurers are having getting to the sites of the devastation. Furthermore, he says that political and human elements may weigh into any decision considering the scope of the losses.

"This is not going to be a typical situation and will be litigated over a long period of time," says Hebard. "The losses could be bigger than what's contractually covered, considering the hardships faced by many jurors in Louisiana."

The uncertainty over the potential payout may be keeping some managers on the sidelines, yet Walid Kassem, portfolio manager for the $112 million

( MDFNX)Merrill Lynch Global Financial Services fund, says it could ultimately be a boon for insurers who will be able to hike premiums.

"In a case like this, you weigh two things against each other. On the negative side, you have the direct impact of the catastrophe in terms of the money that has to be paid out to victims," says Kassem. "On the positive side, you have the increased premiums for future years. The net effect of these two elements tends to be positive."

Kassem's fund owns a mix of property insurers such as

RenaissanceRe Holdings

(RNR) - Get Report

and

PXRE Group

( PXT), as well as casualty or mixed insurance such as

ACE

(ACE)

.

"The historic pattern for catastrophes has been that increases in prices makes up for short-term losses," says Kassem. "The attacks of Sept. 11, for example, had a very high human cost and a high cost to insurers, but insurance companies actually did well in terms of stock performance afterwards. So while it is not something to wish for, it does happen."

Going for Brokers

If there has been one bright spot in the languishing financial sector over the past year, it's been the brokers. While mega-insurers such as

AIG

(AIG) - Get Report

and money-center banks such as

Citigroup

(C) - Get Report

and

J.P. Morgan Chase

(JPM) - Get Report

have seen their shares tread water in the face of a flattening yield curve and one too many bouts of bad press, broker/dealers have powered ahead of the rest of the financial sector, as well as the greater S&P, on the heels of a hot economy. The Philadelphia KBW Broker/Dealer Index is up 14% this year.

"Trading revenues have rebounded, IPOs are back, M&A volume is up, expenses are down. Put it all together and you see why the brokers have the best top-line growth," says Bill Field, a senior analyst covering financial stocks at Pioneer Funds. Field's top pick in the group is

Goldman Sachs

(GS) - Get Report

, which he predicts will have a strong third quarter that will be goosed by a strong commodities business.

Lee Rosenbaum, an equity analyst covering financial stocks at Loomis Sayles, is expecting a similar result from his favorite,

Bear Stearns

( BSC), on account of its bond business.

"Predicting earnings at brokers and predicting losses at insurers is tough," says Rosenbaum. "But Bear is in a growth area in a growing economy, and bonds have rallied this summer, so it should be a very solid third quarter for them."

While exuberant over the prospects of brokers heading into year end, fund managers still tend to be less than sanguine about the third, and largest, leg of the financial stool: regional and money-center banks.

Pioneer's Field says the banks will continue to have a tough time with net interest margins under pressure and deposit costs rising. He also believes 2006 earnings estimates are a little high and will have to come down before the year is through.

"The flat yield curve is not good for your average spread-based lenders," says Burtnick, who nonetheless believes the likes of Citigroup may be bottoming out now that their yields are looking more and more attractive. At 4%, Citi's dividend yield exceeds most utility companies which are now trading at record highs.

In the current tight spread environment, Burtnick and others prefer owning banks that can make money on fees instead of spreads. Cramer fave

Commerce Bancorp

(CBH) - Get Report

has also proven to be a darling of financial services fund managers because of their ability to grow earnings by 20% a year, even as others make excuses about a flattening yield curve.

"The yield curve is flattening for everybody," says Loomis' Rosenbaum. "But these guys still scratch out fantastic top- and bottom-line growth."

To view Gregg Greenberg's video take on this week's Mutual Fund Monday report, click here.