Three Reasons to Ignore the Hype Surrounding Financial ETFs

Includes: IYG, KBE, KRE, QQQ, XHB, XLF
by: Gary Gordon

Goldman Sachs (NYSE:GS) reported weak revenue, Citigroup (NYSE:C) missed profit forecasts and Wells Fargo (NYSE:WFC) merely matched estimates. In truth, JP Morgan (NYSE:JPM) is the only major financial institution that has reported inspirational numbers, but even “J.P.” has problems in its mortgage division.

Herein lies an ongoing dilemma. You can improve your balance sheet by offloading troubled assets and/or writing off poor quality loans. You can ensure a measure of profitability by limiting your employee overhead, maintaining double-digit credit card rates, having some success in trading volume and/or offering next-to-zero savings rates to depositors. Yet financial stocks will still see “fits” without a more potent level of lending to small businesses and individuals.

Lately, many readers have been devouring rapturous reports on the incredible prospects for the financial sector. Hypothetically speaking, economic expansion should encourage greater demand on the part of consumers and businesses alike.

On the other hand, the economic improvement is likely to be stronger for streamlined corporations than for families. Tech, energy, materials and industrials should help buoy stock averages, while higher-than desired unemployment and record foreclosures imply that borrowers will struggle to qualify.

(Why take chances with credit quality ... unless, of course, the government forces lending activity. Oh wait, didn’t government direct and indirect involvement in the lowering of underwriting standards contribute mightily to the financial crisis?)

Scores of professionals are professing new-found love for SPDR Financials (NYSEARCA:XLF), SPDR KBW Regional Banks (NYSEARCA:KRE), SPDR KBW Bank (NYSEARCA:KBE) and iShares DJ Financial Services (NYSEARCA:IYG). On the flip side, I am avoiding the hype surrounding the financial sector. Here’s why:

1. Many Sectors Show Pre-Recession Revenue Records ... Not Financials. Across the spectrum of different industries, you see a wide variety of companies earning more money than ever before. Names include Apple (NASDAQ:AAPL) and Intel (NASDAQ:INTC) in technology, Exxon Mobil (NYSE:XOM) in energy, Vale (NYSE:VALE) in materials as well as Potash (NYSE:POT) in agriculture. In many ways, these corporations are operating as well as they did before the Great Recession.

Can we say the same about the home-builders? How about Bank of America (NYSE:BAC) or Citi? Other than the dirt-cheap valuation argument, Homebuilders (NYSEARCA:XHB) are more of a trade than an investment.

2. The Dot-Com Bubble Is Worth Revisiting. The Nasdaq 100 is often viewed as a proxy for technology, as is the Nasdaq 100 tracker, Powershares QQQ (QQQQ). The Q’s are above the high reached during the 2003-2007, but they still require another 94% to reach the pinnacle of 2000. Even after 10 years, the dot-com strain still lingers. (Cisco (NASDAQ:CSCO), JDSU (JDSU), Sun Micro… then and now, anyone?)

Expect financials and real estate companies to suffer a similar fate due to the credit/housing bubble’s impact. For reference, SPDR KBW Bank (KBE) requires roughly 130% to reach its Q1 2007 high mark.

3. Eerily Similar Circumstances During April 2010 Earnings Season. Not only did U.S. stocks outperform world equities in a 2-month run-up from 2/8/10 to 4/14/2010, but financial stocks led that charge. Their relative strength had been increasing dramatically. What’s more, SPDR Select Financials (XLF) ran for 25% to the S&P 500’s 14.5%. And all the while ... prognosticators were serving up brave new heights for financial stocks.

Then came the earnings disappointments. Nothing terrible ... but very similar to what we are seeing here in January 2011. Sure enough, the financial sector fell more than its peers and struggled for longer than its peers. With financials circa 11/23/10 to 1/18/11 demonstrating an eerily similar pattern to the previously mentioned vertical leap for the sector, could the so-so corporate earnings be the corrective dagger for a giddy marketplace?

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

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