We will freely confess to being only begrudgingly bullish on US Financials over the last few months. We’ve preferred cyclicals of all stripes, but really only found the group appealing because it was simply the cheapest sector in the whole S&P 500. It still is, and by a country mile. The index trades for 22.1x forward 12-month earnings expectations. Financials go for 14.6x and the next cheapest group is Health Care at 16.2x. Cyclicals should be cheap and have earnings leverage to an economic upturn. Financials score on both counts.
But as we often say in these pages “math is not an investment edge”, so PE ratios alone aren’t enough; with the recent breakout in long term interest rates, however, Financials have a legitimately good story to tell. Yield curves steepen when bond markets are convinced economic recovery (and therefore inflation) is at hand. Banks do well in this environment because demand for credit increases and the quality of those and prior loans also improves. It also helps, of course, that the price of new long-term loans is rising more quickly than the cost of deposits.
In every economic recovery since 1990, Financials have always outperformed.
- From November 1990 to November 1993, they went from a 6.8 percent weight in the S&P 500 to a 12.1 percent weight (i.e. they rallied almost 2x as much as the overall index).
- They were among the biggest sector winners after the 1990s dot com bubble blew up, going from 12.7 percent of the S&P 500 in June 2000 to 20.6 percent in December 2002. That’s something to keep in mind just now, with many investors worried about Tech sector valuations.
- Yes, Financials were the root cause of the Financial Crisis and subsequent Great Recession. But once they had gone from 22.3 percent of the S&P 500 in December 2006 to just 9.7 percent in February 2009, they then led US equities higher for an entire year and got back to a 16.9 percent weight in March 2010.
Not that we should expect the same sort of weighting pickup this time around, but we’re certainly off to a good start thus far in 2021. Financials were 10.4 percent of the S&P 500 at year end 2020 and are 11.0 percent now. If you want to compare those numbers to the 3 bullets above, you have to add Real Estate since it spun off from the group in September 2016. The 2 sectors’ combined weights are 13.4 percent at present, still below where they were at year end 2019 (16.0 percent) as well as prior periods noted previously.
As far as how to play Financials for a further rally, 3 thoughts:
#1: The classic approach is to simply buy XLF, the Financials slice of the S&P 500. The problem here is that Banks are just 39 percent of this ETF. Capital market businesses are 26 percent and Insurance is 17 percent. The former has reasonable leverage to economic recovery, but the latter does not. The remainder of XLF is Diversified Financial Services (13 pct) and Consumer Finance (5 pct).
#2: A more targeted approach would be to look at KBE (S&P Bank ETF), KRE (S&P Regional Bank ETF) or IAT (iShares US Regional Bank ETF). KBE and KRE are pretty well atomized (no single name more than 5 pct, 80 – 120 holdings in total). IAT is more concentrated, with 55 names and large weights in Truist (13 pct), PNC (12 pct) and US Bancorp (11 pct). We don’t like single name concentration when playing a macro theme, so we’d recommend you look into KBE and KRE over IAT.
#3: Lastly, there is PSCF – the Invesco S&P SmallCap Financials ETF. On the plus side, you get the beta of small cap stocks (currently 2x the volatility of Large Caps, as we described in yesterday’s Data section). On the downside, PSCF is only 52 pct Banks, Thrifts, Mortgage companies and Consumer Finance. REITs are 29 percent and Insurance is 10 pct.
Summing up: there’s always 2 reasons a given group outperforms – its own fundamentals and market sentiment about other groups – and the bull case for Financials has a bit of both at the moment. We’ll probably always be a bit grumpy about recommending the sector, mostly because it is heavily regulated and technological disruption is a long-term risk. But it still looks good to us here, as much for what it isn’t (large cap growth) as what it is (cyclical).