How Financial Stocks Could Be the Market's Bright Spot

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Traders write orders on the floor just before the closing bell of the New York Stock Exchange

Here's a scary fact to add to today's gloomy stock-market headlines: bank stocks might actually be providing a boost to the market, even as it tumbles to new lows. By at least one measure, financial firms are making the bad earnings caused by the economy look a bit rosier.

Late last week, Goldman Sachs cut its earnings expectations for the stocks in the Standard & Poor's 500. Collectively, Goldman thinks, those companies will earn $40 a share this year, down from $49 a share in 2008. That's a drop of 18%. Not great. But take out financial stocks, and the picture gets worse. Excluding banks, insurers and the like, Goldman is predicting an earnings plunge of 25% in '09. (See pictures of the stock-market crash of 1929.)

What's more, financial stocks are also making the stock market look more attractive — or at least less ugly — to investors. The S&P 500 has a price/earnings ratio based on trailing 12-month earnings of about 15. That compares with a 10-year average P/E of 21. So the market's current valuation looks cheap. But some financial stocks like Bank of America and Wells Fargo have P/Es of 7 and 5, respectively. Take those out, and the market looks more expensive.

"Calling financial firms the bright light of the market would be a very nice way to put it," says Tobias Levkovich, chief U.S. equity strategist of Citigroup. "But what is happening is that last year was the financial crisis, and this year is an economic crisis."

Just a short time ago, market watchers argued that if you were to ignore financial stocks, automakers and homebuilders, the economy actually looked hunky-dory. It now appears that thinking was myopic. (See 25 people to blame for the financial crisis.)

Other sectors are now in the grip of recession. Earnings at energy companies, for example, are expected to plunge 50%. Technology companies could see their incomes drop by a third. Consumer staples — companies like Procter & Gamble that produce toothpaste and toilet paper — could be one of the few sectors to escape the economic downturn. Goldman expects earnings for those companies to be flat in 2009 compared with last year, before rising in 2010.

"There was a lot of wishful thinking that the financial crisis would not extend to the rest of the economy," says Robert Arnott of the investment-strategy firm Research Affiliates. "But that is — and was — naive."

To be sure, financial firms are no model of health. Goldman expects the financial stocks in the S&P 500 to lose a collective $9 a share. By comparison, health-care companies are expected to earn $11 a share this year. In fact, the losses are so big at some of the financial firms that many market watchers are concerned that some of the largest banks will go bankrupt unless they get significantly more government assistance. Indeed, the government last week released a plan to help boost Citigroup's common equity by $50 billion. It is the third round of financial help the government has provided Citi in less than six months. Still, the bottom lines of banks, while ugly, are expected to look significantly better in 2009 than in 2008. And that's not something that can be said of other sectors.

"What more and more people are beginning to realize is that the parts of the market with less damage so far are not going to escape this downturn unscathed," says Arnott.

Read "How to Know When the Economy Is Turning Up."

See pictures of scared traders.