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More gains ahead for U.S. financials? Add to ...

U.S. financials are near the top of the pack this year, with gains of more than 8 per cent in January. But maybe it’s not too late to get in on the rally: Myles Zyblock, chief institutional strategist at RBC Dominion Securities, raised his recommendation on the sector to “market weight” from “underweight” – providing three reasons why you should expect more gains ahead.

1. Capital markets are acting better. That is, the spreads between yields on safe U.S. 10-year Treasury bonds and high-yield bonds have begun to shrink as investors gain more confidence in the abilities of European policy makers to tame the sovereign-debt crisis. As well, inter-bank lending spreads and bank credit default swaps have begun to improve.

2. Employment indicators are looking better. This is a big deal for bank stocks, with Mr. Zyblock arguing that employment statistics usually lead bank lending metrics by about six months.

“Given that U.S. employment data, such as payrolls, hours worked, and the four-week moving average of initial U.I claims, have been coming in stronger as of late, total loan volumes should continue to pick up through at least the first half of 2012,” he said in his note on Jan. 18. Since then, the Labor Department has reported that initial jobless claims for the period ended last week fell to 352,000 – well below expectations, and the lowest level since April 2008.

3. Recovery stories are working better. Since the stock market bottomed out (in the near term) in early October, the value style of investing has been outperforming. This is good for financials, given that typically the stocks in this sector are cheap, based on valuation metrics such as book value and price-to-earnings ratios.

Sure, there are risks here. The European sovereign-debt crisis is perhaps the biggest one, with Greece at risk of defaulting on its debt obligations. There are also regulatory risks, as authorities trying to lower the chances of banks leading the world into another devastating financial crisis.

“We mitigate these risks somewhat by placing our focus on banks, which are leveraged to the improving domestic economy and housing market more so than Europe,” Mr. Zyblock said.

“Domestic banks stocks have mirrored Homebuilders since the peak of the housing bubble in 2006, and housing stocks have been on a tear since last summer. Further supporting this is the fact that both groups have recently broken out of a seven-month downtrend, which should provide good prospects for at least the short term.”

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