Don't Trust the Rally in Financials

It's been a very interesting start to 2009. Four months into the year, we've seen a tale of two halves: The worst performers from the first two months of the year performed best in March and April.

The worst performers? Financials -- the stocks making the news -- continued their upward streak in April, appreciating 22.2%, but they remain down for the year. Financials and utilities remain the only double-digit decliners so far in 2009, which is not all that bad given the remarkable thud with which we started the year.

It is curious to note that things in April developed very similarly to the way they did in March:
Source: Standard & Poor's.

Provided that the S&P 500 had fallen more than 20% for the year in early March, finishing April down only 3.4% for the year is a heroic achievement. One big concern, though, is that this rally is led by the worst stocks -- a characteristic of bear market rallies, as I noted in March's performance wrap-up.

Still, even if this is a bear market rally, that does not mean you should necessarily fight it. As legendary trader Jesse Livermore said long ago, "There is only one side of the market, and it is not the bull side or the bear side, but the right side." With that in mind, let's try to make sense of the numbers.

False dawn for the banks?
While it appears that there's been a short squeeze in the financial sector, fundamentals drive the share price performance in the long term. Large short positions act like lighter fluid poured on wet wood. Yes, the fire burns spectacularly for a short while, but in the end, all you get is smoke.

Mike Mayo, the star banking analyst at Calyon Securities, believes that bank losses will be much larger than those during the Great Depression, leveling off between 3.5% and 5.5% of total loans made.

During the Depression, the loan loss high-water mark hit 3.4%. We haven't reached that point yet, but as I recently read in a Goldman Sachs (NYSE: GS) research report, there's at least another year of climbing bank losses, given our current point in the recession, and the three-year cycles such situations typically follow.

In that light, it is easy to see the recent sharp rise in bank stocks as a massive short squeeze. So to those chasing Citigroup (NYSE: C) and the like because they are "cheap," I say think twice, and instead study company fundamentals. You're better off sticking with well-run banks like JPMorgan (NYSE: JPM) and Wells Fargo (NYSE: WFC).

Three out of 10
Three out of 10 sectors in the S&P 500 are up for the year: technology (16.5%), materials (11.9%), and consumer discretionary (8.3%). I've written before about the merits of tech stocks -- with their low debt burdens and strong cash positions -- so this is no surprise to me. I'm more intrigued about the action in the other two economic sectors.

Materials seem to be rallying on the hope that "less bad" economic numbers mean the worst is over for the U.S. economy. Then there's the Chinese stimulus package, which could mean increased commodity demand. I'm a believer in commodities, but investors shouldn't expect a return to the feverish world economic growth rate we saw in 2003-2007. (At least, not soon.)

The consumer discretionary sector -- a classic sector that leads the market at the end of a recession -- is now in the black for the year. While it seems unlikely that consumers will spend vigorously in times of rising unemployment, stocks usually bottom before the fundamental picture turns, so this is undoubtedly a positive sign.

Target (NYSE: TGT) is one consumer discretionary stock I like -- in fact, back in March, I wrote about how I liked Target better than Wal-Mart (NYSE: WMT).
The key to Target's performance is the recovery of the U.S. consumer. While consumer spending may be less than what it's been in recent years, when the economic shock of late 2008 wears out, Target is well-positioned. Given the strong advance in Target's share price in recent weeks, investors would do well to practice patience and look for pullbacks.

After a monstrous seven-week run, I am starting to wonder if one should not look for a pullback in the broad market, too. This year "sell in May and go away" isn't sounding so bad.

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