Don’t Enter Financial Stocks Just Yet

The reality of an economic slowdown in the United States and globally is something to really consider seriously. On Monday, stock markets collapsed, with the DOW down over 500 points or four percent in a massive one-day sell-off. The selling was triggered by the situation at Lehman Brothers Holdings, Inc. (NYSE/LEH), which opened at $0.19 on Monday after failing to secure any capital infusion and announcing it would seek Chapter 11 bankruptcy protection. The news is not a huge surprise, as the once-powerful Wall Street investment banker has been burdened with debt and credit problems relating to the subprime fiasco. Moreover, the Bank of America Corporation (NYSE/BAC) announced it would buy Merrill Lynch & Co., Inc. (NYSE/MER) for $50.0 billion, as we see some reorganization in the troubled financial services sector. The bottom line is that it was a very nasty day on the stock markets.

Stocks are significantly down across the board, with indices set to retest recent lows in 2008. The selling capitulation in the market may make the Federal Reserve think hard about cutting interest rates at its meeting on Tuesday. The Federal Reserve has poured 10s of billions of dollars into the fragile financial system, along with concerted efforts from other global banks, but the impact appears to be minimal, as the economies continue to show signs of slowing.

The bad news may sound endless, but the reality is the real threat the credit crisis poses to the economy. Add in the higher oil prices and you have a precarious situation.

My view is to wait out the current turmoil and watch for things to improve in the financial sector before jumping back in. The inherent sector risk remains high and makes investments in financial companies vulnerable to higher downside risk.

In my view, it could get worse, as the extent of the financial impact of loans and mortgages may yet to be uncovered. This uncertainty makes financial stocks a very risky bet at this time. Some may view bank stocks as a dividend play right now, but the truth is that the downside risk remains great and an unnecessary risk to take. We want to see some stability to surface before entering new positions because of the downside risk.