How to tell when the financial sector has bottomed out

The banks seem to be turning on each other, downgrading each others' shares and recommending sells. But there are parallels with the dotcom bust – and you may be able to tell when the tide is turning.

Ever wondered why good zookeepers are so diligent about cleaning waste from the enclosures of the animals in their care? I'll give you a hint: It's not because they enjoy that aspect of their jobs! Who would?

Sure, it's for the obvious reasons: sanitation, disease-prevention, odor control. But it's also because animals like to eat. And zookeepers have learned that when in captivity, animals will often eat their own waste after a while because they simply don't know any better. Obviously, this leads to a host of health issues and can ultimately cause serious problems for both the animals and zoos.

What does this have to do with investing? I'll show you

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The animals have turned on each other let the rumble in the jungle begin

Some would say that this sector currently resembles animal waste. It's certainly emitted an overpowering stench across Wall Street in the past year. And like animals fighting for survival, it appears the players have begun to turn on each other.

On Thursday, Goldman Sachs (NYSE:GS) downgraded one of its fellow financial sector members, Citigroup (NYSE:C), slapping the rare 'sell' sign on the company. But Goldman wasn't done. It went a rather shocking step further and actually advocated shorting Citi as well, as it cut the target price on Citi from $20 to $16. The decision was part of a "pair" trade in which it suggested investors sell Citi and buy Morgan Stanley (NYSE:MS).

The news sent Citi shares tumbling to a 10-year low, hot on the heels of Goldman's prediction that Citi will write off a further $8.9bn in debt for the second quarter. It also projected a $0.75 per share loss for Citi during the current quarter, compared with its earlier forecast of $0.25 per share in profits. The full-year loss could total $1.20 per share, versus an earlier projection for a $0.30 per share profit. And in turn, that could force Citi into its second dividend cut this year.

That's one heck of a downward revision.

Admiring the scrap from afar, Wachovia (NYSE:WB) then decided to jump in and issued a "Sell" on Goldman.

Like a farmer fertilising his crops, the financial sector is spreading its muck far and wide. Other analysts, including Banc of America Securities, also project a $3.5bn second-quarter loss for Merrill Lynch (NYSE:MER).

Goldman, of course, goes a step further, pegging a $4.2bn second-quarter write-down for the firm. So what is an investor to make of this?

Wanted: $65bn

One week ago, Goldman analysts declared that American banks need another $65bn in capital to handle the fallout from the credit crunch that has inflicted a savage beating on the sector - and isn't expected to peak until 2009.

William Tanona, the Goldman guy responsible for the Citi downgrade and short sell recommendation, has downgraded the entire brokerage sector from "attractive" to "neutral." He states that the recovery will take a long time because fundamentals have been clobbered.

But if you look across the financial sector board, there's a very interesting development occurring - one that is eerily familiar to the last big US sector blowup

History repeating from dotcom dogfight to financial fracas

Towards the end of the dotcom collapse, all the big names that had been flying high and puffed themselves up at the beginning of the boom, then throughout the rise, started to issue downgrades and 'sell' recommendations once the mess began to hit the fan.

It was the very definition of capitulation. What's odd, however, is that the very definers did not heed their own advice and turned on each other (and subsequently capitulated) at the wrong time.

And it's happening again - except this time with the financial sector.

Most of the big financial firms are issuing 'hold' or 'neutral' recommendations on each other (in investment lingo, these verdicts are merely soft terms for a 'sell'). In some cases, like we saw Goldman do on Thursday, they're issuing full-on 'sell' recommendations.

Bottom line: The current rout in financial sector shares might smell awful to the simple onlooker. But smart investors should know that it smells like the beginning of the end of their collapse, too.

I took a look at the beaten-down financials after Goldman issued its downgrade and 'sell' recommendation on Citi and some of them actually rallied a little. What does that tell you?

Don't look to the big name, attention-seeking analysts to tell you when to buy. Instead, turn to them when they tell you to sell. That's when you'll know that the bottom in financials is near.

This article was written by by Karim Rahemtulla for the Smart Profits Report