By John Spence

Some of the more speculative financial stocks that have been powering the U.S. market's gains cooled Monday.

U.S. stocks got the week off to a rocky start as the latest plunge in Chinese markets rattled investors. However, the financial sector firmed up a bit Monday after a report on manufacturing activity came in better than expected.

The Financial Select Sector SPDR Fund, an exchange-traded fund indexed to large-cap financial stocks, was off nearly 1% at $14.65.

"Light volumes and a continued 'flight to risk' marked a week where banks that have lost money outperformed their more stable peers," said Stifel Nicolaus & Co. analysts of the rally in a note Monday.

The financial stocks as a group, they pointed out, actually lagged the S&P 500 Index last week, "largely reflecting profit taking within the sector."

Bucking the downward trend, E-Trade Financial Corp. (ETFC) rallied 9.8% to $1.80 as Citadel Investment Group said it's terminated a plan to sell up to 120 million shares of E-Trade common stock.

KKR Financial Holdings (KFN) stock rose 20% to $3.90 after JMP Securities upgraded the stock to outperform and set a $5 price target.

Meanwhile, shares of Morgan Stanley (MS) slipped 2.7% to $28.71 as Bank of America-Merrill Lynch downgraded it to neutral from buy and trimmed the shares' price target by a dollar to $32.

The stock is no longer deeply undervalued, said research analyst Guy Moszkowski in a note to clients. Morgan Stanley shares were up 84% so far this year through the end of last week.

Troubled financial-services companies - the darlings of the sector's summer rally - saw their shares moving lower to start the week and dominating the list of most actively traded stocks.

Shares of Citigroup Inc. (C) fell 2.9% to $5.07 , Bank of America Corp. (BAC) fell 1.1% to $17.78, American International Group Inc. (AIG) was off 8.6% to $45.93, Fannie Mae (FNM) fell 3.4% to $1.97 and Freddie Mac (FRE) was down 4.2% to $2.30.

Also weighting on investor sentiment was a weekend report from banking analyst Dick Bove at Rochdale Securities in which he warned about the short-term outlook for the sector after the rally.

"There has been a remarkable change in the valuation of bank stocks in the past 12 months. In the fourth quarter of 2008, the industry was feeling the effects of mass hysteria. Now, the mood has changed to rampant euphoria," the analyst wrote.

"Long-term investors are advised to keep their positions because they are likely to be rewarded," Bove said. "Nearer-term investors might consider the fact that a reaction to the recent move up in the stocks may develop."

Citi shares traded weakly in the wake of a weekend Barron's article warning investors the stock is no longer a bargain. Near-term gains are likely to be limited and some investors should consider taking profits, according to the article.

Highlighting the frenzied trading in financial stocks, shares of AIG, Fannie and Freddie have more than tripled in August.

In other banking news Monday, the New York Times reported that taxpayers are seeing early profits as a result of big banks paying back their bailout debts to the federal government. Meanwhile, the Financial Times calculated that the Federal Reserve has made a $14 billion profit on loan programs designed to stabilize the financial system.

-John Spence; 415-439-6400; AskNewswires@dowjones.com