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Unrelenting pessimism over fallout from the mess in sub-prime mortgages has weighed heavily on the Financial Sector SPDR (NYSEARCA:XLF), which is down about 10% year-to-date, making it the worst performing S&P 500 sector by far. But the focus on tidbits of negative news to the virtual exclusion some very positive numbers for the sector as a whole may mean that investors have overreacted. Specifically, we see three factors that could make XLF a very attractive investment for the second half of the year:

Earnings estimates are rising—not falling.
Although debt-related problems are a hit to earnings in some places, they are not the only factor impacting earnings. Since the start of this year, analysts’ estimates have risen steadily, despite the fact that the sub-prime issue has been known about for quite some time. Strength in other areas, particularly in mergers and acquisition activity (which brings tremendous fee revenue to banks and brokers), has more than offset weakness in the credit market (Figure 1).

Actual results are strong. With three-quarters of all S&P Financial firms having reported Q2 results, including virtually all banks and diversified financial firms (leaving mainly insurance companies and real estate investment trusts), sector earnings look like they will be up a decent 7.8% versus Q2 of last year. But what’s impressive is that expectations were for just 2.8% growth at the start of earnings season. That five percentage point difference is the largest upside surprise of any sector, and it is by far the largest contributor to the “strength in S&P 500 earnings” we often hear about in the press.

XLF is cheap. If our analysis is correct that on the whole fundamentals in the sector are improving, not deteriorating, then Financials appears compellingly cheap. XLF currently trades at 11.2x 2007E EPS—with several of the largest, most stable institutions trading at single digit price-to-earnings multiples—compared with 15.4x for the S&P 500 (Figure 2). XLF also has a dividend yield of 2.9% which, if not something to write home about, still compares favorably to the paltry 1.9% yield on the S&P 500.

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Source: Financial Sector: The News vs. The Numbers