Is the party over for financial stocks?

When federal regulators accused Goldman Sachs and one of its executives of defrauding investors, the stock market plummeted Friday over fears that other financial institutions may face similar scrutiny or tighter regulation. Now, investors face the question of whether to scale back their exposure to the financial sector after its long rally from last year's lows.

Heading into Friday, banks had been on an extraordinary run. In the last year, the New York Stock Exchange Financial Sector Index had climbed nearly 50%, easily outpacing the 36% gain of Dow Jones Industrial Average. However, those gains appeared less stable in the aftermath of the suit announced Friday. Bank stocks and funds suffered immediately. KBW Bank fund (KBE), an exchange-traded fund that tracks the stocks of big names in the financial sector such as Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C) and serves as a proxy for large-cap financials overall, fell 3% on Friday.

The critical issue for investors is whether the SEC will go after other financial intuitions in the days ahead. If so, the current malaise over the financial sector could become a more permanent thick fog, says Doug Roberts, chief investment strategist at Channel Capital Research in Shrewsbury, N.J. If all of a sudden this leads to a series of charges, then it could certainly have more serious consequences on the sector as a whole, he says.

Here s what happened Friday. The Securities and Exchange Commission alleged that Goldman and Fabrice Tourre, a former vice president at the company, created and sold opaque financial instruments known as collateralized-debt obligations, or CDOs, which hinged on the performance of subprime mortgage-backed securities. The complaint, which was filed in U.S. District Court for the Southern District of New York, charges that Goldman marketed these securities to customers, while failing to disclose that a major hedge fund client had a role in picking the securities and was betting against them.

In a statement, Goldman affirmed its innocence and called the SEC s accusations completely unfounded in law and fact. Regardless of the company s innocence or guilt, however, analysts say that the complaint will likely weigh on Goldman stock, as well as the broader market for days to come.

When asked about whether the financial regulator was pursuing charges against other institutions, a spokesman for the SEC said the agency doesn t comment on cases yet to be filed or speculate about future complaints.

Roberts, who reduced his exposure to financials months ago, says more suits may be in the offing. However, the fact that the suit against Goldman is civil rather than criminal suggests that the government has a unique motive in this case, he says. They just want financial retribution, Roberts says. You don t bail out Wall Street with $2 to $3 trillion and send the bill to Main Street; that isn t going to fly in an election year.

The SEC is able to bring only civil charges against institutions. For criminal charges, the Department of Justice would have to step in, says John Heine, an SEC spokesman.

Some analysts say the case has little bearing on where financials go from here. Other lawsuits and issues tied to the mortgage debacle will continue to surface, says Jeff Kleintop, the chief market strategist for LPL Financial. Investors do need to keep in mind that while these companies are having a rebound in earnings, this suit, along with the emphasis on financial reform, depicts something of a new normal for financials, he says.

Still, investors should have already been expecting some pullback and now is an ideal time to take profits, says Kleintop. We were due for a 5% to 10% pullback, he says, adding that if the Goldman case hadn t driven a correction, perhaps the Federal Reserve s meeting later this month would have. There have been concerns about a rate hike leading up to a meeting on [April 28], he says.

The financial sector still faces another hurdle: Financial regulatory reform remains in the works, and a Senate vote is looming. Democratic and Republican lawmakers seized on the Goldman news Friday to make their case for their own brands of reform. Kleintop says some version of regulatory reform was likely to have been passed this year anyway, but the Goldman charge has offered new ammunition to lawmakers to make oversight more iron-fisted. Companies may face stricter rules around financial products, he says. That may too negatively impact the profitability of Wall Street.