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Craig Allen: The Financials Will Lead the Recovery

Providing credit where it's due, the financial sector is the key to stronger growth this year — no matter what the 'experts' say

Much has been written about the financial sector, especially given the widespread collapse of the U.S. and global financial markets in late 2008/early 2009, and the ongoing challenges we face with government and individual debt levels.

As recently as December, many pundits, including Jim Cramer of Mad Money fame, were highly vocal about their disdain for this sector of the economy, and their beliefs that these stocks should not be owned.

In the United States and increasingly across the globe in both developed and developing economies, however, economic recoveries cannot be sustained without financial companies providing the financing necessary to fund the recovery. If we are to have a sustained (true) recovery in the United States and globally, we must have the financials actively participating by providing the life’s blood of any modern economic recovery: credit.

We’re now in the midst of earnings season, with most companies reporting their 2011 fourth-quarter earnings during January and into February. For the financial sector, the results have been surprisingly positive overall, with most of the major companies reporting solid performance for the fourth quarter.

There have been some disappointments, however, adding fuel to the fire of speculation surrounding expectations for the future prospects for this sector. During the last few months of 2011, just as Cramer and many others were openly discussing the possibility of a major bankruptcy in the financial sector, with Bank of America cited as one possible casualty of the recession, the financial stocks were at their lowest point collectively, since the worst of the stock market reaction to the Lehman Brothers bankruptcy in late 2008.

Financial stocks made a low in early October, rallied briefly, and then fell again to set a slightly higher low in late November. During December, Cramer (and many others) advised to sell financials, especially Bank of America, with BofA (NYSE symbol BAC) hitting its lowest point since early 2009 at $4.92 per share. On Dec. 19, the same day, the sector overall, as tracked by the XLF (Financial Select Sector SPDR Fund), hit its low for the month at $12.21 per share. Many investors, concerned about the poor price performance of the financial stocks and the volume of negative news coming out of Europe, and influenced by the likes of Cramer, sold financial stocks in December, at or very near these lows.

Unfortunately for these investors, the pundits were dead wrong (as usual). The financial stocks rallied significantly from the lows of December and were further buoyed by positive earnings reports across the industry from some of the largest firms, not the least of which was Bank of America, which reported better than expected revenues and in-line profits (excluding items) of 15 cents per share, up from 4 cents in the year-earlier period. BofA’s net income was $2 billion, compared to a loss of $1.2 billion in the same period a year ago, and for the full year, it posted a profit of $1.4 billion against a loss of $2.2 billion in 2010.

This positive performance for BofA propelled the stock up dramatically from the December low, pushing it up 44 percent from the December low to the high last Friday. The financial sector also powered to impressive performance, with the XLF rising to a high of $14.16 on Friday from the December low, which represents a 16 percent gain for the sector overall.

Where do the financials go from here?

The financial sector has not achieved this impressive performance in a vacuum. The S&P 500, which closed last week at 1,315 (the high for the day), gained a massive 13.5 percent from the Nov. 25 low of 1,159, and 9.4 percent from the Dec. 19 low (during the same time-period as the financials sector gained 16 percent).

In fact, the S&P 500, after making such a substantial move in such a short period of time, may be due for a pull-back. This possible pull-back could (and in my opinion certainly would) drag the financials down with it. From a technical perspective, there is a lot of resistance for the S&P 500 around the 1,350 level. If we get that high in the short term, it would not surprise me to see the market sell off as much as 10 percent, especially if we get some bad news from Europe, such as some or the rumored country downgrades from Standard & Poor’s.

Based on the recent strong advance for the market and especially for the financial stocks, I have trimmed positions in the financials sector and across the board for the portfolios I manage. While I am bullish on the market for the long term, and have a 1,500 target for the S&P 500 for 2012, I routinely raise cash at times when I feel there is a significant risk to the downside. This is one of those times.

There are many corrections that will take place within a long-term bull-market trend, just as there are rallies during bear markets. I look for a short-term pull-back in the overall market, and within the financials specifically. I will view a pull-back as a strong opportunity to add positions in the financials (and in other high-growth areas of the market — namely in technology, consumer discretionary and industrials), and will be a buyer if and when these stocks correct.

I believe any sustained recovery in the U.S. economy must be financed by the financials, and that we will not have a recovery otherwise. With this stated, I do believe 2012 will be a transition year with 3 percent to 4 percent GDP growth, leading into a stronger pace of growth in 2013. If this analysis is accurate, the stock market should perform very well in 2012, especially in the second half of the year, anticipating stronger growth to come, and the financials should outperform the overall market, as they benefit by providing the credit that is essential to any sustainable recovery.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.

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