(Recasts, updates share prices)
BANGALORE, June 23 (Reuters) - Goldman Sachs & Co strategists urged stock investors on Monday to "underweight" U.S. financial and consumer shares, admitting it was wrong when it upgraded both sectors just seven weeks ago.
The downgrades sparked selling in the two sectors as investors feared that weakening consumer demand and deterioration in the credit markets will weigh on profitability.
"We boosted our consumer discretionary and financials weights in May on the belief the sectors would benefit from bank recapitalizations and fiscal stimulus," Goldman strategists led by David Kostin wrote. "Our thesis was clearly wrong in hindsight."
Goldman had previously urged investors to overweight consumer stocks and maintain a neutral weight in financials.
In afternoon trading, the Standard & Poor's Financials Index .GSPF was down 1.8 percent while the S&P Consumer Discretionary Index .GSPD was down 1.1 percent. The S&P 500 .SPX, in contrast, was up 0.2 percent.
Among the decliners was Merrill Lynch & Co MER.N, whose shares were down 3.4 percent after a Banc of America Securities analyst projected a wider loss for the securities firm.
"Banks are what's weighing on the market," said Steve Goldman, a market strategist at Weeden & Co, citing the Goldman Sachs report.
Financial stocks had fallen 18 percent since the May 5 upgrade, compared with a 5 percent drop in the S&P 500, Goldman said, as investors grew increasingly worried that more lenders would cut their dividends and conduct dilutive capital-raisings as losses mounted from mortgages and other debt.
Consumer discretionary stocks, which include such industries as cars, clothing and leisure, fell 7 percent in the same period, the Goldman strategists said.
Many analysts have been concerned that the tax rebates the government began handing out earlier this year might not provide much stimulus for the U.S. economy as debt-burdened consumers use them to pay bills or buy increasingly expensive necessities such as food and gasoline.
Besides, the strategists asked, "What sustains consumer spending after the tax rebate checks have been spent?"
Goldman urged clients to allocate 13 percent of their holdings in S&P 500 stocks to financials and 7 percent to consumer discretionary stocks, compared with respective index weightings of 15.1 percent and 8.3 percent.
"The credit situation facing the consumer is still deteriorating, house prices are falling sharply, and unemployment is rising," Goldman said.
The strategists urged investors to overweight the energy, materials and information technology sectors, saying they will likely outperform in an environment of rising inflation and weakening consumer demand. It rates those sectors "overweight." (Reporting by Supantha Mukherjee, Dinesh Nair in Bangalore and Ellis Mnyandu in New York; Editing by Deepak Kannan, Jarshad Kakkrakandy)