Hold off on financial stocks
Now may not be the time to go bottom feeding, but there are some signs you can look for when it's time for a rebound.
NEW YORK (Fortune) -- It's a simple rule of thumb: When earnings drop, stock prices follow suit. But when earnings rebound, that doesn't mean stocks will bounce back as well - unless they're financial services stocks, which rise and fall alongside profits, says FBR Funds President and Chief Investment Officer David Ellison.
Funds that specialize in financial services stocks are down about 47% overall this year, according to Morningstar. And like many other fund managers Ellison has suffered, but his funds have outperformed their industry counterparts.
Ellison's FBR Small Cap Financial Services fund is down 10.7% - making it the least battered performer in the group - and his FBR Large Cap Financial Services fund is down 31.4%.
Despite the substantial losses, Ellison says the sector has one thing going for it that other industries lack: a historically strong correlation between earnings and stock price.
"Stocks have gotten crushed because earnings have gotten crushed," he says. "That means when the earnings recover, the stocks should go up. The question now is when are we going to get to a point where we can feel more comfortable about the earnings? No one knows."
Ellison may not be able to pinpoint when earnings will rebound, but he has identified the factors that will move the industry, impact earnings and, in turn, stocks. Here's what to look for in the year ahead:
Accounting adjustments: Companies need to clean up and more fully disclose off-balance sheet items. When it comes to bank accounting, Ellison looks for what he calls the "three C's" - consistent, comprehensible and conservative.
Banks that following these guidelines will generally report lower earnings in the short-term, but over the long term their stocks will earn higher price/earnings multiples from investors.
Regulatory adjustments: As regulators require banks to have bigger capital cushions, banks will cut back on lending, hurting earnings. But here again, there will be a long-term benefit: higher multiples for bank stocks as investors grow more comfortable that bank earnings are real and sustainable.
Interest rates: Among other things, the significant decline in interest rates means that homeowners who can refinance will do so. The result is banks will find themselves with a "barbell portfolio" - a whole bunch of low-interest-rate mortgages that don't earn you any money and a whole bunch of high-interest-rate mortgages that don't pay you anything, Ellison says. His sense is that rates are going to stay low for five to 10 years, if not longer.
Credit: This is what everyone's focusing on right now, and there will be continued stress, with default and delinquency rates rising. Expect to see an increase in commercial and industrial delinquencies down the road.
With the headwinds facing the sector's earnings, Ellison doesn't view financial services as an attractive place to invest right now. Desirable companies seem very expensive on a relative basis, but cheap stocks may have hidden risks in their portfolios of loans.
He has about 50% of both his funds' assets in cash and is waiting it out. He owns what he thinks is safe and tries to buy the best-managed companies.
His advice to investors: Be cautious and wait for clarity. Don't worry about missing the bottom of the market, because right now, there are too many unknowns. "Stay away until there's vision. If you're going to invest in the sector, make sure you know what you're investing in," he says. "Don't take a flier on something and hope."
Ellison is waiting for home prices and unemployment to have stabilized for a solid period of time as an indicator of when to get back in the market. Home prices are key because their decline sparked the downturn, he says, and unemployment is critical as most people service debt with their earnings instead of a savings account.
"Because everyone is so debted up, job loss has a much bigger impact on the financial institutions than it ever has," he says.
One thing to look forward to in all this is the potential for big gains when the market recovers.
"You make most of the money in financial services going from bad to good, not from good to great," he says. "And conditions are bad now, no question about that." 
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