Financials Flash a Warning Signal

Includes: GS, LEH, MER, MS, SPY, UBS, XLF
by: Scott Snively, CFA

The bellwether financial sector (NYSEARCA:XLF) has not participated in the broad market's 3-day rebound this week. Today, under pressure from subprime losses and downgrades, the group is extending its decline. The XLF was a valuable leading indicator for the broad market in 2007, and may be sending a warning to investors once again.

Last year the XLF completed a "double top" on June 1, and was already down 5% when the broad market peaked in mid-October. The XLF offered an unambiguous turnaround signal on Jan 22, the S&P 500 (NYSEARCA:SPY) followed one day later. By Jan 24, the XLF was up 10.9% over 3 sessions. The S&P 500 lagged behind with a modest 2.0% gain.

Now the market sees a bullish "higher low" formed by the S&P last week. However, the momentum at the XLF has been negative since Feb 1. The XLF was down 0.6% yesterday and has declined 8.6% in less than 9 sessions.

UBS (NYSE:UBS) is the latest big bank to remind us that the subprime mess will not go away. UBS reported $13.7B in Q4 subprime losses. The bank has $27.6B of subprime exposure as of December and sees difficult 2008 ahead.

Yesterday, Dow Jones reports that auction-rate securities [ARS] are beginning to fail. This $300 to $350 billion market depends on past liquidity levels to fund auction-rate resets every 35 days. There are now too few buyers at these auctions and many corporate treasurers are now getting stuck with an asset that was once considered a safe place for short-term money.

In the Wall Street Journal's "Heard on the Street" column, the writers reviewed old fears that off balance sheet structured investment vehicles [SIV] may need to return to the parent banks' books due to backstop provisions. Such a move would tie up precious capital at the banks and reduce lending.

Now earnings estimates for the big investment banks are coming down. Deutsche Bank (NYSE:DB) cut its Q1 EPS estimate for Goldman Sachs (NYSE:GS) to $2.63 from $4.64. The Reuters consensus Q1 EPS estimates for Lehman (LEH), Bear Stearns (NYSE:BSC), Goldman (GS), Morgan Stanley (NYSE:MS) and Merrill Lynch (MER) have declined by 24.5%, 35.0%, 20.9%, 19% and 48.9% respectively over just the last 90 days. (BSC, GS, LEH and MS report Q1 earnings in mid-March.)

The AMEX broker dealer index was down 0.6% yesterday and 8.7% since Feb 1. The KBW Bank Index also down 0.6% yesterday, and has declined 8.4% since Feb 1.

Other key market indicators including semiconductors (SOX-1.1%) and retailers (RLX -1.4%) were also lower in yesterday's trading. Meanwhile, interest rates are going up for long treasuries. The 10-yr bond is yielding 3.79%, up 32bp from January 22, while the 30-yr yield is at 4.60%, up 42bp from January 22.

Disclosure: none