Our Outlook for Financial-Services Stocks

• An extended rally in financial-services stocks has drastically reduced the number of bargains in the sector.
• Emergency liquidity provisions have lessened the chances of a funding crisis in Europe, but the sovereign debt crisis is not over. 
• Hints of an economic recovery have improved the prospects for rate-sensitive names.

A bout of renewed optimism about the prospects for the global economy resulted in a dramatic rally in financial-services stocks in recent months. The aggregate Morningstar price/fair value ratio for stocks in the sector rose to 87% from 78% during the quarter. A few stocks remain undervalued, but with the European sovereign debt crisis still unresolved, the Chinese economy possibly slowing, and a long way to go before the U.S. economy returns to full steam, we think investors should remain cautious as they wade back into the sector.