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When should you buy financial stocks? This seems to be the single largest item of conversation and discussion on all the stock investment talk shows these days. Financials have been beaten and battered by the recent problems in the housing markets and seem to be cheap. Plus, they have tempting dividends.

But I do not want you to fall into that trap. Most of the big banks and financial institutions are closely tied to the housing markets, and the housing markets are quite frankly a disaster right now. I see continued financial write-downs, mostly due to escalating mortgage woes, over the next five to six quarters. In fact, the housing market may not improve until late 2009, due to excess inventories.

Some investors seem to think that continuing interest rates cuts by the Fed will be the cure-all fix. While the Fed's cuts should help get our economy back on track, we're only in the second or third inning of the credit crisis. Housing prices are down 13% this year. That is the largest drop in 37 years. New home sales are down over 20%. The inventories of existing homes for sale are at a 22-year high according to the National Association of Realtors. Mortgage delinquencies and defaults are rising fast. The recent bailout plan for consumers announced by the President probably is not going to help that much, as very few homeowners will actually qualify for the program.

The Fallout From CDOs and Sivs

Much of the freefall in the financial sector's operating profits can be blamed on the collapse in derivative securities, especially Collateralized Debt Obligations, known as CDOs, and Structured Investment Vehicles, or SIVs. The only bright spot that I can see is that maybe the massive multibillion-dollar write-downs from major banks and financial institutions might get a bit smaller in the upcoming quarters, but that's about it. In fact, the chart below illustrated just how dangerous a place financial stock investments are right now.

The chart above illustrates how steep the freefall has been. The decline in operating profits of the S&P 500's financial sector are attributable to not just mortgages, but also to the collapses in derivative securities, es­pecially CDOs and SIVs. All seemed well until the middle of last year, when the you-know-what hit the fan. Then the operating profits of financial companies took a nosedive, literally.

But the biggest reason not to buy financials, no matter how tempting or how much airtime they get on television is that their fundamental and quantitative scores are terrible. I am constantly telling investors to watch their portfolios carefully and check out their stocks on my proprietary stock-screening database,  PortfolioGrader Pro. I recently took a look at some of the leading financial stocks in PortfolioGrader Pro and their scores were terrible. Although most of them had good cash flow rankings as their losses have impacted their balance sheets, not their income statements, the rest of their scores were terrible. The highest earnings momentum score was a C from Wells Fargo (WFC), some were Ds, but the majority got Fs. Only Goldman Sachs (GS) scored better than a D for analyst earnings revisions. Analysts are universally downgrading their expectations for these companies. This is hardly an environment for gains!

By using our Fundamental and Quantitative Grades found in PortfolioGrader Pro, my Blue Chip Growth subscribers steered clear of financial stocks most of the year. We sold the last one, Goldman Sachs (GS) at a 17% profit back in September. Goldman has been unique among banks and brokerages as they have seemingly navigated the dangerous waters–not just surviving, but thriving. Nonetheless, its shares became too risky as measured by its Quantitative score, so we sold it.

When should we invest in financial stocks? Truthfully, I do not know. I do know at some point whether late in 2008 or even 2009, the rate cuts will provide a steeper yield curve and the banks will be profitable again. At that time, their Fundamental grades will start to improve, and that will cause buying pressure to move the stock prices. Because of tools like PortfolioGrader Pro, we will be there ready to buy. But it is not today, nor do I expect it will be soon.

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