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) 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) -- 2.89%
  • American International Group (AIG) -- 6.17%
  • Bank of America (BAC) -- 8.47%
  • Citigroup (C) -- 6.86%
  • Goldman Sachs (GS) -- 3.81%
  • JPMorgan Chase (JPM) -- 6.39%
  • Morgan Stanley (MS) -- 2.30%
  • U.S. Bancorp (USB) -- 2.37%
  • Wachovia (WB) -- 3.39%
  • Wells Fargo (WFC) -- 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) -- and exposure to a domestic recession, an extended consumer and to a protracted downturn in housing.

And significantly, the financial sector -- including money center and regional banks, multiline brokerages and monoline insurance/credit card entities -- have been almost universally managed by a host of corporate posers -- for instance, Stan O'Neal at Merrill Lynch ( MER), James Cayne at Bear Stearns ( BSC) and Charles Prince of Citigroup -- who took uncommon risks that initially produced common returns but which have now morphed into unprecedented write-offs and loss of permanent capital.

"Buy when the factory doors are padlocked; sell (or short) when the rate of earnings growth is phenomenal. That growth will not prove to be sustainable."
-- Roy Nueberger, Neuberger & Berman (told to me when I was a young one back in the early 1980s)

Roy Neuberger, the founder of Neuberger & Berman, taught me the lesson above that I have never forgotten. It is a lesson (which can be viewed as supportive of financials) that has saved and made me a lot of money over the past decade.

That said, buying the XLF is more than just a contrarian play.

Someone less famous than Roy, but closer to my heart, Grandma Koufax, used to put it this way, "Dougie, buy/short on your analysis, sell/cover on the news."

The ride in financials will not likely be a smooth one -- profitability has been impaired and will be slow to recover -- but, in the fullness of time, it may be a profitable one.

Here's why.

Permanent capital is being replenished. While costly and dilutive to existing shareholders, the curative process is now well under way (though ignored by investors). Sovereign wealth funds (Kuwait Investment Authority, Abu Dhabi Investment Authority, China Development Bank, Singapore's and Temasek Holdings all with Citigroup; and Government of Singapore Investment Corporation with UBS ( UBS)), private equity (Warburg Pincus with MBIA ( MBI)), hedge funds, long-term institutional investors (Davis Selected Advisors with Merrill Lynch), domestic corporations (Bank of America with Countrywide Financial ( CFC)) and international corporations (Citic Securities with Bear Stearns) have recently infused much-needed capital to shore up financials' capital bases.

Government policy will not be standing still. Treasury Secretary Paulson's first pass at shoring up the mortgage market got an F from The Edge. It was dead at birth. Nevertheless, more cogent policy is likely ahead (formulated by both the Republican and Democratic parties). This might be especially true in an important election year.

The seized-up credit markets will not be a permanent condition. Indeed, improving Libor and TED spreads (recently ignored by the marketplace) are seemingly presaging a more normal credit market. Historically, this has been constructive for the financial sector.

Credit writedowns will likely peak in fourth quarter 2007. I estimate that about $125 billion to $135 billion of writedowns will have been taken in the financial sector in 2007; that figure should drop to only $35 billion to $50 billion in 2008. If this is correct, financial sector profit growth could add several percentage points to the S&P's 2008 earnings.

The opaque disclosures of 2004 to 2007, bogus pricing and "marked to modeling" of earning assets (especially of a credit kind) have been replaced by vicious, monumental and historical writedowns. Though this is difficult to quantify, it is possible that if the recession is relatively shallow, then the period of maximum pain is now behind most financial institutions. (My view has been clear -- namely, that the recession will be deeper and longer than most expect, but I could be wrong. And a portion of every portfolio should be viewed as a hedge against one's economic blueprint.)

Many managements have been turned over -- and more will be in the near term. The ne'er-do-wells have been replaced by more sober and experienced managers (e.g., John Thain at Merrill Lynch, Alan Schwartz at Bear Stearns and Vikram Pandit at Citigroup). The credit mistakes of the past will not be repeated in the near term -- at least not until the next cycle of overexuberance and folly in financial product offerings.

Business franchises are intact. While principal activity will no doubt be curtailed, financial companies' agency businesses -- including underwriting, merger and acquisitions, asset management, retail brokerage, etc. -- are intact and will remain so as the cycle runs its course again. Indeed, one can make the argument that the larger, more established and better capitalized entities will gain market share at the expense of its competitors.

Financials are statistically cheap against sustainable earnings. As seen in the statistics that I began this column with, financial shares are attractive on a valuation basis.

Financials have dramatically underperformed relative to the S&P 500. While one trading day does not make a trend, it is interesting to note that the financials not only withstood the dramatic market weakness on Friday but many financial stocks rose by 1% to 2% on that day. Friday's absolute and relative strength in financials was relatively broad-based and conspicuous.

XLF One-Year (Amex)
Financial Select Sector SPDR
Click here for larger image.
Source: Yahoo! Finance

Finally!
At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.