Financial Giants Split on Whether the Worst Is Over

Is it time to jump back into beaten-down financial stocks--or is it still too early?

Even the financial giants themselves can't agree.

Goldman Sachs said Tuesday that it has selectively upgraded shares of financial services companies as well as the brokerage and asset manager sectors.

But the firm remains cautious on stocks of regional banks, mortgage and specialty finance companies and real estate investment trusts.

Meanwhile, Merrill Lynch chief investment strategist Richard Bernstein warns against the dangers of "bottom-finishing" in financial stocks.

"We continue to suggest underweighting financial stocks because of the myriad of risks facing the sector. This applies to financials in a global context, not simply to U.S. financials," Bernstein wrote in "The RIC Report."

In upgrading the brokerage and asset manager sectors, Goldman said the recent fears have been exaggerated and are mostly reflected in the prices of the stocks. Both sectors were upgraded to attractive from neutral.

"We have reached an inflection point for stocks with little credit exposure, or where exposure is marked to market," Goldman said in a research note. The firm expects a recovery in equity flow trends in the second half of 2008, but said this anticipated rebound is not yet priced into the stocks.

"Many stocks offer upside twice that of downside risk, balance sheets are strong, and looking a bit further out to 2009, valuations appear extremely compelling," said Marc Irizarry, an analyst at the firm.

Notably, Goldman added shares of Franklin Resources (NYSE: ben) and NYSE Euronext (NYSE: nyx) to its Convinction Buy List. These two stocks were upgraded to buy from neutral. Goldman also raised the price target of Franklin shares to $135 from $110, while the price target of NYSE shares was raised from $87 to $82.

It also reiterated its conviction buy list rating for Morgan Stanley (NYSE: ms)shares.

Merrill Says Underweight Financials

However, Merrill Lynch's Bernstein reiterated the view that investors remain underweight on financial stocks.

Merrill's U.S. as well as global quantitative strategy groups view financials as significant "value traps" -- stocks that appear to be undervalued, but have no visible catalysts to keep them from becoming even more undervalued.

European and U.S. insurance companies, however, remain the preferred industry within the overall sector, Bernstein said.

The analyst noted that investors appear to have considered only credit conditions and have largely ignored the coming slowdown in global growth.

Investors are just starting to realize that the deflation of this credit bubble is not simply a "US subprime problem," Bernstein said.

"Indeed, they are just beginning to see a tightening of global credit markets. The cost of capital is rising around the world, and financial markets are beginning to react to that fact," he said.

Bernstein, however, said a contrarian view suggests that investors should start considering how financial companies will eventually grow once the sector goes through what promises to be a considerable consolidation and balance-sheet repair process.

"The sources of growth for tomorrow's financial companies are likely to differ from those of today. The challenge for the long-term investor is to identify the catalysts for that future growth," he added.

Fannie, Freddie Debate Rages

Debate at the brokerages also raged regarding Fannie Mae (NYSE: fnm) and Freddie Mac (NYSE: fre).

Goldman expects credit losses at the government-backed lenders to increase rapidly this year and exceed a peak last seen in the early 1990s.

"We expect government-sponsored enterprise credit costs to increase throughout 2008, and remain at elevated levels to 2010 and perhaps beyond," analyst James Fotheringham said in a note to clients, in which he reiterated his sell rating on the two stocks.

The credit losses will likely be most severe for mortgages backed by homes in "speculator states" such as California, Florida, Arizona and Nevada, he said.

However, Lehman upgraded shares of Fannie and Freddie to overweight from equal-weight, citing the companies increased political standing, their ability to deploy capital and high-return investment options, which have improved over the past few weeks.

Lehman expects the companies' stocks to "outperform" on steady market share gains and high returns on new business.

Goldman was more favorable on shares of American Express (NYSE: axp), Bank of New York Mellon (NYSE: bk), and Janus (NYSE: jns), which all were upgraded to buy from neutral.

Shares of Discover Financial (NYSE: dfs) were upgraded to neutral from sell, with its 12-month price target increased to $17 from $14.

However, shares for Marshall & Ilsley (NYSE: mi) were downgraded to sell from neutral, with its price target reduced to $22 from $26.

Meanwhile, shares of Wells Fargo (NYSE: wfc), Zion Bancorp (NASDAQ: zion), Lazard (NYSE: laz), Federated Investors (NYSE: fii), Knight Capital (NASDAQ: nite) and Och-Ziff Capital Management (NYSE: ozm) were all downgraded to neutral from buy.

Goldman Sees Headwinds at Regional Banks

Goldman expects the regional banking sector to still face headwinds in the construction and home-equity lending.

The banks that are believed to be most at risk from capital strain include Citigroup (NYSE: ozm), Wachovia (NYSE: wb), Huntington Bancshares (NasdaqGS:HBAN - News) and First Horizon National (NYSE: fhn), Goldman said.

Goldman added it is "particularly concerned" about funding risks for commercial lenders such as CIT Group (NYSE: cit), iStar Financial (NYSE: sfi), NewStar Financial (NASDAQ: news) and CapitalSource (NYSE: cse).

--Reuters contributed to this report.

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