By Angela Moon and Ryan Vlastelica
NEW YORK (Reuters) - Even experienced Wall Street contrarians are eyeing the beaten-down U.S. financial sector warily.
The sector is down 20 percent this year, by far the worst performer in the S&P 500. The weakness has been so pervasive that the S&P, which is down 1.8 percent in 2011, would be up 3.3 percent on the year if financials were excluded, according to Standard & Poor's Equity Research.
Most market participants agree these stocks are set for a rebound over the long term. They still appear too risky for short-term traders.
Arguably, this is when intrepid bargain hunters who buy into investor fear would be snapping up the beaten-down sector. But the problems dogging banks all year - from the debt crisis in Europe to the bleak outlook for profits - do not appear to be abating.
"Our job is to buy low and sell high. With financials, I'm still questioning, 'What is low?'" said John Manley, chief equity strategist for Wells Fargo Advantage Funds in New York.
The aversion to financials is great. Assets in bank-focused funds have dropped by 40 percent in the last six months, and the group is the only one of 10 S&P sectors trading at less than the value of the assets on their books.
Market participants cite various reasons for financials to decline further, including regulations, weakness in the housing sector and fears linked to Europe's escalating debt crisis.
"Valuations are attractive, but there has to be a catalyst to move prices higher and I just don't see that," said Peter Coleman, director of research at JMP Securities in San Francisco.
In the last six months through the week ended December 7, the assets under management (AUM) in the U.S. financial/banking funds sector have dropped a net $8 billion, or nearly 40 percent, according to Thomson Reuters' Lipper U.S. Fund Flows database.
Assets in the sector hit a peak in February 2011 of nearly $23 billion in AUM. Since then, it's been mostly outflows.
Investors have remained skittish due to the worries about Europe. The predominant investing strategy this year has been to trade on macro events, specifically the euro zone debt crisis.
Whenever the outlook for Europe worsens, the banks are punished, particularly brokerages such as Morgan Stanley and Jefferies & Co, on fears of exposure to Europe. It has contributed to high volatility in the sector.
"The things that made these stocks cheap are still around. It's still a risky business and you have no idea how bad business can get until they really get bad," said Manley.
That's contributed to making banks more undervalued than any other sector based on anticipated growth.
By StarMine's current estimates, the financials are priced at 57 percent of their intrinsic value, compared with 72 percent for the S&P. Intrinsic value is where StarMine believes a stock should trade based on likely growth over the next decade.
"If you have a three to five year timeline you'll look back at today's prices and wish you bought in, but I don't see anything to move them higher over the next 12 months and I just can't ignore the headwinds," said Coleman.
This is the reason the market capitalization of the bank sector is less than the value of the assets on their books. The combined market cap of the sector is $1.68 trillion, compared with book value of $1.95 trillion, according to StarMine.
OPTIONS AND DOOM
Even the options market does not suggest optimism for the future. Last week open interest on the Select Sector Financial SPDR fund , which tracks the S&P financial sector, reached its highest since the financial crisis.
Put options outpaced call options by a ratio of 1.7, according to Interactive Brokers. Normally, the ratio is between 1 to 1.2.
When Bank of America shares fell to a fresh two-year low of $5.03 last week, instead of betting on a rebound, option traders moved to hedge themselves against more declines.
"There's a group of high-quality banks that have bottomed, but Bank of America isn't one of them," said Marty Mosby, large-cap bank analyst at Guggenheim Partners in Memphis, Tennessee.
Mosby listed Wells Fargo, US Bancorp and Bank of New York Mellon among those where "we haven't yet reached an inflection point where their strong fundamentals will drag prices up in a risk-averse market."
Among individual names, the put-to-call open interest ratio on Goldman Sachs was 1.11 while Citigroup's ratio was 0.62.
"I think what you would find looking at trades on specific names is that there are traders positioning for a range of scenarios from recovery to disaster," said Caitlin Duffy, Equity Options Analyst at Interactive Brokers.
Even some of those speak positively about the banks are staying cautious. BNY Mellon's wealth management core portfolio recently moved to a slight "overweight" position on the group due to the bad news already priced into the sector.
"As a group, banks are fairly valued, however it's understandable that we're going to be cautious about moving to a large overweight at this time," said Leo Grohowski, chief investment officer at BNY Mellon Wealth Management in New York.
"This could turn out to be an outstanding entry point, but it depends on your risk appetite... there could be more risk than potential reward."
(Reporting by Angela Moon and Ryan Vlastelica; Additional Reporting by Dan Bases; Editing by Andrew Hay)