US Large Cap Financials Are A Train Wreck

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US Large Cap Financials Are A Train Wreck

Large cap Financials are the only reason the S&P 500 is down for the year to date. Not Tech (still up 2.5%). Not Consumer Discretionary (+4.9%). And those two sectors’ returns are enough to offset declines in lesser-weighted sectors like Industrials (-10.4%), Materials (-14.3%) and Energy (-12.7%).

Here is the math:

  • Financials are 13.1% of the S&P 500 and the group is down 12.5% YTD.
  • The group’s average weighting in 2018 is closer to 14%, so that YTD decline is worth 175 basis points of drag to the S&P 500 (12.5% times 14.0%).
  • The S&P 500 is 1.4% lower in 2018, but without Financials its YTD performance would be +0.4% (1.4% plus the 1.8% from the prior bullet).

We’ve covered two reasons for the recent weakness in Financials in these notes (end-of-cycle loan growth data and a flattening yield curve) but we want to add one more today: pronounced weakness in European banks. Three points to consider:

  • The MSCI European Financials Index is down 26% YTD. Most of that decline has come since October, with the group off 18% from late September through today.
  • After shrugging off the first part of this meltdown, US Financials are now catching up quickly. The 30-day correlation between American and European Financials is now 0.76; it was lower than 0.50 in early October.
  • Also consider that US small cap Financials have not gone along for this drop. They remain comfortably above their late-October lows and are only down 3.5% on the year. Both US and European large cap Financials are making new lows on a daily basis just now.

So when will US large cap Financials finally bottom? Two thoughts:

#1. Valuation isn’t the answer; even bears will agree the group is cheap.FactSet currently shows S&P Financials trading for 11.1x forward earnings, the lowest sector valuation in the entire S&P 500. Even if you assume estimates are 20% too high, that still yields a 13x multiple in a market trading for 15.4x.

#2. The history of the sector weighting for Financials in the S&P 500 provides a more useful signal that also captures the capital markets cycle quite neatly.Here is how this works:

  • At their current weighting of 13.1%, Financials are at their lowest percentage of the S&P 500 since May 2009, barring a one-month downdraft in September 2016. (We use month end data here).
  • The average Financials weighting in the index since 2000 is 15.4%. When we showed a long time Financials analyst this dataset, he reminded us that going back any further ignores industry consolidation, IPOs and the growth of publicly held asset managers.
  • The average weight of Financials since 2010 is a similar 15.5%. That this foots with the 2000-present experience gives us some confidence that this is a “normal” allocation to Financials across a cycle.
  • The post 2000 troughs are June 2000 (12.7%) and February 2009 (9.7%).

The bottom line here: either US large cap Financials are near a bottom relative to the S&P 500 (like June 2000) or markets are still in the midst of discounting something much worse (like 2009). By any objective measure, it should be the former (a relative bottom). The US financial system is robust enough to withstand a “normal” recession, or the Fed’s annual stress tests are basically worthless. The group may not V-bottom, but it should be safe to even weight or perhaps even modestly overweight right here.

Our advice: a more positive view on this sector can wait a few weeks. We are big believers in “price leads fundamentals”. The recent coupling of US to European Financials is troubling, because the American financial system is nominally better capitalized than the Eurozone’s. Markets don’t seem to care…

And a final thought: we will be closely watching how US large cap Financials trade into year-end. They should stabilize soon, indicating a cyclical low in market sentiment. The group may not outperform, but it should match the S&P’s performance. If Financials continue to break down, that is very bad news indeed.