Is the Trouble in Financials Just Beginning?

• By Ron DeLegge, Editor
• On 11:53 am EST, Monday November 24, 2008

SAN DIEGO (ETFguide.com) - Let me first begin this article by congratulating Citigroup's executive management (NYSE: C - News) for convincing theU.S. government to give it $20 billion in fresh capital and guaranteeing $306 billion in toxic assets.Mission accomplished!  

Think about it: Pandit's Citi gang was able to accomplish what the gang at Bear Stearns and Lehman Brothers couldn't do. Good thing too. Citigroup was on the verge of becoming Citi Bear Brothers Group.    

With more than 200 million customer accounts in over 100 countries and a prestigious roster of Blue Chip shareholders, Citigroup has long been considered one of the leaders within the financial sector. But as we're now learning, it's become less of a leader and more of a ringleader - the kind which accumulates devastating multi-billion losses that annihilate stock prices and shareholder value.

But let's not scapegoat Citi. The entire financial sector is in the midst of an epic shakeout where other breathtaking casualties nobody thought were possible will happen. The end is not yet near.  

The financial sector consists of companies involved in commercial and retail banking, investment brokerage, insurance, and specialty finance. Key exchange-traded funds (ETFs) following this sector are the Financial Select Sector (NYSEArca: XLF - News), iShares Dow Jones U.S. Financial (NYSEArca: IYF - News), and the SPDR KBW Bank ETF (NYSEArca: KBE - News). So far this year, financial ETFs have lost between 50-65% of their value.

Things in the financial sector began to worsen after Treasury Secretary Hank Paulson reversed course by saying the U.S. government would not be purchasing the billion-dollar mistakes of financial institutions through its Troubled Asset Relief Program (TARP). Question for Hank: Is this the way you treat the industry sector that helped make you rich?

While much of the focus has been on banks, they aren't the only ailing companies within the financial sector.

For example, insurance companies continue to get pummeled on concerns about their capital strength.

Shares in Lincoln National (NYSE: LNC - News), MetLife (NYSE: MET - News) and Hartford Financial Services Group (NYSE: HIG - News) are all sharply down for the year. In a sign of desperation, some of these companies have snapped up small banks in order to make themselves eligible for federal bailout funds! The general logic is this: Insurance companies don't want to be at a disadvantage to rivals that get federal aid.

Does this sound like the kind of industry sector that deserves your confidence, faith, and investment?

Perceptive investors say no.  

According to SEC disclosures ending September 30th, billionaire investor Nelson Peltz held puts on the SPDRs (AMEX: SPY - News) along with a position in the UltraShort ProShares Financials (NYSEArca: SKF - News). Both investment strategies are designed to increase in value when stocks fall.

At the opposite spectrum, a handful of mutual funds haven't lost faith (or their shareholder's money).

Since the beginning of the year, the Legg Mason Value Trust (NasdaqGM: LMVTX - News) has cratered 63.66% and the Third Avenue Value Fund (NasdaqGM: TAVFX - News) has fallen 53.09%. Even though mutual funds like these have been marketed and sold under the premise of 'diversification', they are really closet sector funds with concentrated holdings in financial stocks. Don't let the outside label fool you.

It's important that you not contaminate yourself with the Kool-Aid from Wall Street's delusional thinkers.

The ailing financial sector does not represent a classic stock picker's market. In fact, it wasn't a stock picker's market when it was down 5% and now that it's down more 60%, it's still not a stock picker's market. And if you're foolish enough to believe otherwise, hurry up and jump in, because there's still plenty of time to join burned fund managers and their much poorer shareholders. Misery loves company, right?

Two weeks ago, we told subscribers to our ETF Profit Strategies Newsletter not to touch financial shares.

We stated, 'Even for contrarians with nerves of steel, we suggest avoiding XLF. The road to recovery will be long, hard, and filled with lots of government meddling.' Were we right? Since that time, XLF has fallen another 32%. Put another way, a $10,000 investment in XLF two weeks ago melted to around $6,800. Conversely, we've held SKF in our Capital Defense Portfolio for over one-year, bagging a 125% gain.

After the dust settles, which by the way, we're no where close to being, the whole financial sector will be swimming with a lead anchor around its neck that says, 'Rules and Regulations.' Put another way, the entire industry will face the strictest most burdensome rules it's ever experienced in its history. (Do you not remember that the Securities Act of 1933 and Investment Company Act of 1940 came shortly after one of the worst financial periods in U.S. history?)

In the meantime, theU.S. government and its dazed cavalry of financial types will continue to repeat their mistakes. Performing CPR on dead patients/corporations is futile work. The only way real progress can be made is by holding corporations and their executive flunkouts fiscally accountable by letting them fail. Once all of the toxins have been vomited from the financial system's body, then it can heal.

Whatever's coming in the form of new rules for the financial sector it will not be good for capital growth or corporate profits. In other words, the trouble for financials is just beginning.

Buzz up!