Wells Fargo & Co. is among the big financial conglomerates included in the Financial Select Sector SPDR Fund.Peter Foley/Bloomberg
The current bull market in stocks could run for several more years, according to Jonathan Golub of RBC Capital Markets and other market strategists. Why so? The recession and financial crisis of 2008 has left the global economy mired in a trajectory of modest growth and low inflation, which removes the incentive for central banks to bring in restrictive policies that lead to recessions (other factors can knock bull markets but they usually aren't terminal like recessions).
As business cycles progress, certain sectors tend to come to the fore. At this point, the slow-moving and extended business cycle in the United States is favouring the housing and technology sectors. To this list, we can add financial companies. Six years into the current market uptrend, their stocks still appear to be worth owning; the same goes for exchange-traded funds (ETFs), such as Financial Select Sector SPDR Fund (XLF-N) and SPDR KBW Regional Banking (KRE-N).
U.S. financials have been an unloved group for many years because of multibillion-dollar lawsuits filed against them by regulatory bodies and the tough regulatory environment put in place after 2008, among other things. But as quarterly financial results come in stronger, dividends and buybacks increase, the litigation wave crests, and asset quality improves under the new regulatory framework, that mindset is beginning to wane, according to Rafferty Capital Markets analyst Richard Bove and others.
Yet, the financial sector is still one of cheapest in the U.S. market. For example, the Financial Select Sector SPDR ETF has a price-to-book value of 1.3, close to the level seen during the turmoil of 2008 and about half the current reading for the S&P 500. In the boom phase of past economic expansions, financial stocks have risen above three times book value.
The business cycle gives a lift to financial institutions when the economy runs out of slack and starts bidding up wages and investing in new plants and equipment. Producer and consumer prices begin to creep up and bond holders start to demand higher yields to compensate for the loss in purchasing power on their interest payments. Then, as bond yields edge up relative to short-term rates, margins widen on bank loans (banks borrow at short-term rates to lend at long-term rates).
At the same time, loan volumes will climb as economic activity builds. So will transactions in financial markets: this applies not only to the buying and selling of securities by investors but also corporate initiatives such as mergers and acquisitions and initial public offerings. The bigger banks run sizable operations that collect fees from these market transactions.
According to Zacks Equity Research, U.S. financials had the best growth profile of all industry sectors in the second quarter. Total earnings were up nearly 9 per cent from the same period last year, with 70 per cent of companies beating earnings-per-share estimates. "Better expense management, rising fees from surging M&A activity, lower litigation charges and growth in trading businesses were some of the reasons for strong results," Zacks noted.
Not contributing much to earnings growth in the second quarter were interest-rate margins on loans. Given the low-growth rut in the United States, inflation may take some time to reach the point where it nudges up bond yields to sustainably higher plateaus. When it does, loan margins will contribute much more to bank revenues and earnings.
Eventually – even further down the road – inflation may become enough of a concern to the U.S. Federal Reserve that it gets serious about raising short-term rates until they are above long-term rates – what is called "inversion of the yield curve." This has been a reliable sign in the past of impending recessions (one reason being that zero or negative loan margins tend to choke off bank lending).
However, history shows that the inversion of the yield curve takes about two to three years to come about after the initial rate hike by the Fed. So, the current bull market, as Mr. Golub of RBC Capital Markets argues, still appears to be headed for a multiyear extension given we need to first see inflation pick up and then a succession of Fed rate hikes.
XLF is one of the cheapest financial ETFs, with an annual expense ratio of 0.15 per cent. It includes the financial conglomerates such as Wells Fargo & Co., JPMorgan Chase & Co., Berkshire Hathaway Inc., Bank of America Corp., Citigroup Inc. and Goldman Sachs Group Inc.
An alternative financial ETF is KRE. It concentrates mostly on U.S. regional banks, so it would be affected more by loan volumes and margins than transaction volumes in financial markets and the drag of a higher U.S. dollar on exports.
BMO Equal Weight U.S. Banks (ZBK-T) equal-weights U.S. banks and trades on the Toronto Stock Exchange. It may be preferred by Canadians who don't have spare U.S. cash in an account, or wish to avoid currency conversions (perhaps because of the high cost or low value of the loonie).
Disclosure: The author has positions in XLF and KRE.
Larry MacDonald is an economist, author and financial writer who blogs at larrymacdonald.serveblog.net/home.