It is tempting to declare the recent rally in financial shares, and the market in general, the real deal. After all, some formerly bearish (and respected) analysts believe the upswing indicates a real turn in the markets, or, at least, is likely to continue. Mark Faber, publisher of the “Gloom, Doom and Boom Report,” and a longtime bear, believes this rally has room for another 10 percent, as the government actions have essentially given firms “free money,” increasing equity values. And the longtime bears at boutique brokerage Portales Partners have been more positive since February, believing the worst to be over for California housing prices. Portales has been recommending Bank of America shares since February.

Portales made a great call on BofA, whose shares are up by more than 200 percent since CEO Ken Lewis declared in February that his bank would return to profitability in 2009. Other financial firms' CEOs have been making similar noises.

Lewis' view, shared by bullish analysts, is that the recent carnage in the financial services industry has reduced competition and left the surviving players with a greater share of the consumer deposits and loans market. With fewer banks chasing business, pricing can improve, boosting revenues. This leaves the surviving players with a higher “franchise value,” or ongoing operating profitability, and once the credit issues that have plagued these companies subside, they will be able to generate even stronger income. In this view, the banks' income before accounting for credit losses will grow, and the credit losses will be manageable enough to prevent insolvency. “Now is a great time to be a bank — if you have a clean balance sheet and can make new loans with reasonable risk provisions,” says Jason Browne of DAL Investments, an investment manager and publisher of the highly regarded NoLoad Fund*X newsletter. “Some regional banks are well capitalized and stand to benefit from current monetary conditions. For those banks, the challenge is in facing stronger regulations, higher costs for FDIC insurance, and the simple fact that consumers need to re-build their balance sheets, which takes time.”

Investors have also drawn comfort from the Geithner plan on toxic assets, the so called PPIP, which will use public funds to help capitalize sales of distressed securities from banks to asset management firms. And banking stocks got another boost from FASB's loosening of its “mark to market” (MTM) accounting standards, which allow banks to delay loss recognition in assets they believe will recover in value once markets stabilize.

The Bears

Naturally, there is healthy disagreement. Browne is not bullish on the sector. “Despite tremendous stock price declines,” he says, “it is difficult to paint a picture where banks are undervalued, at least as pertains to the major banks. When we hear about banks generating operating profits in the first quarter of 2009, it becomes clear that the problem isn't the ability to lend profitably, but rather the challenge of a badly damaged balance sheet that overhangs our banking system.”

Browne is concerned about the ultimate performance of outstanding loans, believing that we have not yet reached the peak in losses for the cycle, a view echoed by several analysts we spoke to. “Loans are going bad faster than banks are able to earn money,” Browne says. “The relaxing of the mark to market rules doesn't erase the fact that banks need their loans to continue performing. When unemployment is surging and consumer balance sheets are badly damaged, it is easy to identify scenarios where loan losses accelerate, something several banks simply cannot afford. Resets for variable prime and alt-A mortgages are scheduled for the next few years, and the impact could be even greater than what has occurred with sub-prime loans.”

And some observers are skeptical on the MTM change and PPIP plans as well. “I think Geithner's PPIP program is the best program to come out of Treasury, but I don't understand why the banks would be willing to sell their assets under this program without having their arms twisted,” says Vahan Janjigan, the editor of the newletters Forbes Growth Investor and Special Situation Survey. “The assets are already written down, so why sell now? It's not like they will get a great price under PPIP. The bottom line is housing.”

Other challenges remain, and not just for the mortgage lenders. “In the insurance sector, companies have written business, such as annuities, that is tied to equity and credit market performance,” says John Buckingham of Al Frank Asset Management. “Without continued improvement in both equity and credit markets, many insurance companies will continue to flounder.”

One of the more worrying things about this rally is the lack of credit market participation, as prices for credit instruments related to financial stocks, ranging from mortgage-backed securities to preferred shares of large banking firms or credit default swaps on these firms, remain in the doldrums.

What is the best way to play the sector given the massive move up and the recent spate of good news? Skeptical investors might conclude it is too late to add new funds. For advisors running diversified portfolios that are still underweight the sector, adding exposure in names with strong balance sheets and limited mortgage exposure might be the best way. Don't be fooled by low P/E or P/B ratios, or high dividend yields. Traditional valuation metrics are difficult to apply in the midst of such ongoing asset writedowns. Says Buckingham, “As for the names we have been buying, we generally find them to be well-managed, with histories of successful navigation through difficult times and/or excellent growth potential and/or strong franchises that should garner additional market share. Of course, they also boast extremely inexpensive valuation metrics, though in the current environment, traditional financial fundamentals are not necessarily germane.” Buckingham is slightly underweight financials, but has been nibbling of late, adding Wells Fargo (WFC), BB&T Corp. (BBT), MetLife (MET) and Nasdaq OMX Group (NDAQ) to his main diversified equity mutual fund.

“I believe that the ‘quality’ names will survive the carnage and go on to thrive on the other side. The key is getting from here to there, which is why a strong stomach and broad portfolio diversification is necessary,” says Buckingham. He also owned Goldman Sachs and Morgan Stanley shares.

But, in the end, who knows what evil lurks in the balance sheets of the major financial institutions?