Sector Research – The Financial Sector
The US stock market continues its uptrend and is already up 10.3% YTD and 13% YoY. Earnings momentum is strong (S&P earnings grew by 16.5% in Q1 2017, the highest EPS YoY growth since 2011, and by 10.1% in Q2 2017). Volatility is low, which is positive for stocks – the 50-day moving average of the volatility index VIX is 10.41. However, compared to their European and Asian counterparts, US stocks start to look overvalued and some repositioning might add value to the portfolio. It is a good time to look at which sectors are well positioned to outperform the market on a relative basis. No doubt, the technology sector is the best performer so far in 2017, and prospects are looking bright. Another sector worth investing and diversifying our favorite tech portfolio is the financial sector, due to several macroeconomic fundamentals and a mix of industry-relevant factors summarized below:
The US economy is experiencing sustained expansion – the current cycle is already 8 years long. Interestingly, analysts argue that the economy’s sluggish growth means that the current cycle has a still a long way to run;
The expectations for higher inflation growth needed to be adjusted downward, as the economy accelerated during 2010-2014, but since then began expanding at a steady rate. The 10-year U.S. Treasury yield is trending down in 2017. Another reason for the softer inflation expectations is that achieving the tax reform under President Trump’s administration in 2017 starts being questioned, as the debate over details of the changes becomes more and more intense. According to analysts though, the economic expansion will gradually cause upward pressure on wages and inflation. As an answer to that, the monetary policy reaction should eventually result in higher yields. As the market participants start to price the inflation risk and further rates hike risk, the yield curve steepens. This is positive for banks as they can increase their net interest margins, which can be simply defined as the gap between deposit and lending rates;
More on rate hikes - higher interest rates will directly help the financial sector by boosting industry revenues. Based on the economists’ expectations, the Fed will start unwinding its balance sheet in September and raise interest rates in December;
Loosening lending standards may boost loan volume growth which is a key driver for the sector - commercial and industrial loan creation has slowed in recent years, resulting in decelerating total loan growth. But loosening lending standards, already evidenced in residential mortgage industry reports, could break that trend and benefit financial sector stocks;
President Trump’s agenda – bank stocks gained close to 20% only within a month after the election. According to Goldman Sachs, this premium gradually evaporated, as the Republican-controlled Congress is not being able to pass a reform bill enabling the banks to take increased risks;
This leads to the next point – financial sector stocks seem relatively cheap right now. In view of the rising dividends in the sector, expected by analysts, and the positive Federal Reserve stress test results released in June;
Relative valuations - looking at relative sector ratios the financial sector and telecom appear inexpensive. The financial sector had the lowest relative valuations of any sector in Q2, based on its low price-to-earnings (P/E) and price-to-book (P/B) ratios. Referring to Fidelity’s scorecard, the financial sector doesn’t seem as an attractive opportunity straight away. The sector is under performing the broad S&P 500 index (8.4% vs. 10.3% YTD) and in fact does not shine in the matrix of 4 KPIs - business cycle, fundamentals, relative valuations and relative strength. However, the sector is definitively positioned as the best diversifier if technology and healthcare start to lose momentum. With this in mind, financial stocks can be used in relative trades – for example being long financial stocks, while shorting the broad index or another sector which is considered to be overvalued.
As a conclusion, the financial sector seems well positioned for a bounce in the medium run, as a combination of factors point to the sector being undervalued and thus providing diversification benefits. How to invest - depending on the type of the investor, their risk tolerance and return objectives, one can choose between:
Sector ETF – the most traded are Financial Select Sector SPDR ETF (XLF), Vanguard Financials ETF (VFH), SPDR S&P Bank ETF (KBE);
Single stocks – the big bank names are always preferable - JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, Bank of America, KeyCorp, etc.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.