Wondering how the

S&P 500

will perform over the next few months? Try looking at the financial sector for clues.

Financial stocks make up 21% of the S&P 500's market capitalization and contribute 29% to the index's overall earnings. If any one sector can determine how the overall market will perform, this is it.

The good news for investors is that from a fundamental perspective, the outlook for banks and brokers is perhaps more positive than it's been in the last three years. And while some analysts consider the sector pricey, they've been wrong about that before during the current cycle.

At the nation's banks, asset quality has recovered significantly, with nonperforming loans and net chargeoffs down significantly from a year ago. Chargeoffs are accounts receivable that will likely go uncollected.

"One of the biggest problems for most large banks has been the poor performance of their corporate loan books," said Craig Woker, an analyst at Morningstar. "We're really seeing the bottom and that's going to be a big thing that helps."

Meanwhile, a wave of mergers and acquisitions is helping firms cut costs and drive share prices higher. On Monday,

National City

(NCC)

agreed to buy

Provident Financial

(PFV)

in a $2 billion deal, while

North Fork Bancorp

(NFB)

said it reached a $6.3 billion all-stock agreement to buy

GreenPoint Financial

(GPT)

.

"You've got to think there's going to be a continuation of the consolidation theme," said Tim Ghriskey, president of Ghriskey Capital. "It's just too obvious for it not to occur. There are too many synergies and too many economies of scale to ignore."

All of this M&A activity is likely to be a boon to the brokerage sector, which should see investment banking fees pick up. More than 840 mergers have been announced since the start of the year and their combined value of $164.7 billion is the highest it's been in four years. The market for initial public offerings has also improved recently, with 22 U.S.-registered IPOs being brought to market this year compared to just three in the same period a year ago.

While analysts do expect a slowdown in bond trading this year after huge growth in 2003, they note that stock underwriting, merchant banking, retail brokering and securities clearing should offset weakness in that area. So far, Bank of America analyst Michael Hecht said the fixed-income business has been "remarkably resilient."

The financial sector is now expected to grow earnings by 20% in the first quarter and 11% for the full year, according to Thomson First Call.

Still, there are reasons to be cautious. For one thing, some analysts say financial stocks fully reflect all the good news. Since the start of the year, the sector has rallied nicely, with the Philadelphia banking index up 3% and the Amex Broker dealer index up nearly 12%. The S&P 500 has gained almost 4%.

"Overall I don't see many striking bargains within the financial sector," said Woker. "If there's performance, it's probably going to be momentum-driven rather than anything to do with a fundamental change in the outlook."

The prospect of higher interest rates this year is also a concern. David Rosenberg, chief economist at Merrill Lynch, said financial stocks typically underperform the market both before and during a tightening cycle.

Financial institutions have been a major beneficiary of historically low interest rates. Banks have boosted their profits by borrowing short-term funds at low rates and lending money out at higher interest rates. This phenomenon -- which is referred to as a "carry trade" when done with long-dated bonds by hedge funds -- is likely to be less profitable if the

Fed

increases its short-term target rate. Higher rates would also hurt big mortgage lenders and brokers who securitize and trade mortgages.

Ghriskey dismisses fears of a rate hike, however, saying the Fed isn't likely to move until December at the earliest. The central bank has vowed to remain "patient" in raising rates this year, citing slack resource use and weak employment growth. In any event, Ghriskey said an improvement in the capital markets should compensate for higher rates. What's more, he believes that valuations are reasonable at current levels.

"Valuations might appear high because we're looking at depressed earnings," he said. "Once we see corporate lending pick up, we should see earnings increase significantly."

If he's right, the S&P 500 could be in for bigger gains this year than many analysts currently expect.