A Financial Value Trap That The Market Is Missing

| About: Financial Select (XLF)

SPDR Select Sector Financial ETF (NYSEARCA:XLF) looks to track the financial select sector index. The fund is comprised of commercial banks, insurance companies, diversified financial services, real estate investment trusts and other financial industries.

There is support in XLF at this level and investors are starting to call a bottom in the financial sector once again. I wouldn't get excited about the rally just yet. I expect financials to see a relief rally after such a steep decline. The XLF dropped 30% from February highs but I think the selling isn't done yet.

The financials appear to be setting up a classic value trap. There hasn't been any improvement in the economy that could signal that bank assets are going to appreciate. The financial sector earnings don't show signs of improving any time soon.

Here are some of my concerns:

Mortgage Applications - Mortgage Bankers Association reported that its seasonally adjusted index of mortgage application activity, declined 2.4 percent in the week ended August 19. The loan requests for home purchases declined 5.7 percent, which is a 15 year low.

Mortgage Delinquency - Mortgage Bankers Association announced that the second quarter mortgage delinquency rate increased 8.44 percent.

Jay Brinkmann, MBA's Chief Economist, said: "Mortgage delinquencies are no longer improving and are now showing some signs of worsening".

This could be an issue for banks, marked to market rules force banks to write down assets as the market falls. If bank assets continue to deteriorate they may be forced to increase their capital which could hurt shareholders. This is due to leverage limits which banks must maintain.

Declining Loan Portfolio - It will be difficult for banks to increase their lending portfolios during an economic slowdown. Mortgage applications are dropping and I don't see that trend changing. We need to see improvement in our job numbers and an improving economic climate.

I'm not calling for another financial crisis or that we are going to see major banks and REIT's fail. I do believe financials will survive another economic slowdown, but they aren't out of the woods yet. The economy is not close to turning a corner. The US recently got downgraded and we are faced with a slowing economy once again. This is definitely not the type of environment to see the financials make a large upside move.

The XLF will definitely be a great long term buy but I feel there is still some downside. Many analysts are calling a bottom based on price-to-book valuations and price-to-earning ratios, but the issue are those numbers are based on the financials current situation. Financials are in a deteriorating situation at the moment.

Earnings are going to be an issue going forward. Add in declining asset values and I don't see how financial stock valuations won't be impacted. This makes XLF a short for me until financials can show growth once again. There is a possibility of a relief rally but It won't be sustainable.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.