Financials have had a good year so far in 2013, with the XLF (SPDR Financial ETF) up about 22% year-to-date, led by Goldman Sachs (GS), Morgan Stanley (MS), JPMorgan (JPM), Wells Fargo (WFC) and the Chicago Mercantile Exchange (CME), and a host of other names.
In the 1980's and 1990's, the old market adage was, "As Financials go, so goes the Market", and no doubt that has been true this year so far. Financials have long been thought of as the "market generals" and when financials were one of the leading sectors, it usually meant that the stock market in general was having a decent year.
As a percentage of the S&P 500, Financials are 16% of the S&P 500 today, well down from their peak of 30% in 2007. One big reason we are overweight Financials in client portfolios is that - according to ThomsonReuters data - the Financial sector has been seeing positive earnings revisions and stronger relative and absolute growth for most of 2013, and really this trend started later in 2012. So far, nothing has changed, as you can see from the table below:
* Sector earnings and S&P 500 estimates courtesy of ThomsonReuters
The reader can quickly see that Financial sector earnings growth estimates have slowly gained steam the last 9 months, while earnings estimates for the S&P 500 as a whole has trended lower as we have moved through 2013.
"Absolute" earnings growth is expected to be strong, with analysts estimating +18% for 2013, with 7 months remaining in the year. But also, "relative to the S&P 500, the Financial sector has been trending higher, while the S&P 500 has been trending lower.
The trends driving Financials earnings growth are readily apparent:
Brokers like Goldman Sachs and Morgan Stanley are seeing the best IPO, merger and acquisition (M&A) and credit underwriting markets in 10 years. The low level of interest rates has pushed corporate and high-yield bond market issuance through to all-time highs starting in August, 2012, and M&A deals for 2013 year-to-date, are running as strong as 2007.
The banks are benefiting from a recovery in housing, since banks are tangential housing plays given their residential and commercial real estate exposures. Credit costs and reserves are coming down given the stronger economy, and the next shoe to drop is commercial loan growth, which is just starting to grow. Net interest margin (NIM) compression will start to abate, when the belly of the Treasury yield curve starts to get a positive slope.
The exchanges will see stronger volume and new product growth from the swap market derivatives, not to mention greater Treasury volume as interest rates normalize.
There aren't many brokers left after the remarkable CDO and mortgage-driven credit collapse of 2008, but our largest brokerage position is Goldman Sachs as well as a smaller position in Morgan Stanley .
Current 2013 and 2014 earnings per share (EPS) estimates are $14.42 and $15.30, respectively, for expected year-over-year growth of 2% in 2013 and 6% in 2014. As 2013 stands right now, the 2013 EPS estimate is probably far too low.
With the death of proprietary trading, Goldman's earnings power was cut substantially, but I now think GS can earn $20 at some point, with an upward sloping equity market and a less stressful and slow normalization of the credit markets and interest rates. And $20 in EPS times a normal 10(x) multiple is $200 fair value.
I do think the second quarter's '13 estimate of $2.93 is too low. Goldman earned $4.29 in the first quarter, 2013. Goldman hasn't forgotten how to make money in favorable capital markets.
Jamie Dimon and JPMorgan are still mopping up the London Whale fiasco, but both that nightmare and the specter of Dodd-Frank should begin to fade as we head into the 2nd half of 2013.
JPM is more like GS than Wells Fargo given JPM's Capital Market exposure, so I think of JPM as a lower-octane investment bank, with a better dividend.
Current EPS estimates for JPM for 2013 and 2014 are $5.70 and $5.92, with expected earnings growth of 9% and 4%, respectively. This is actually better expected growth than Goldman.
I think at present there is a "regulatory and headline" discount in JPM's stock price given that the Jamie Dimon CEO / Chairman position discussion and the London Whale incident have kept the bank in the headlines in the wrong way.
Analysts have never been good or accurate predicting capital market attribution for brokers and large banks, or at least that was my experience in the 1990's. That applies to both good and bad markets. Ultimately, I think GS can earn $20 and JPM $7 in EPS in just normal markets. So far 2013 is a bonus.
In what might turn out to be the surprise of 2013, CME's two big contracts are the Treasury complex and eurodollars, but the growth over the next few years, could come from the credit swap market, as credit swaps, which almost took down the entire U.S. financial system in 2008, get standardized and marked-to-market.
The CME has 99% of the Treasury complex market share in terms of Treasury futures. Recently the exchange has gotten a boost from eurodollar volumes as U.S. interest rates and the volatility driven by worries over the Fed's "tapering" program, has driven volatility in the eurodollar.
Current 2013 and 2014 EPS estimates for CME are looking for $3.15 and $3.62 for expected growth of 4% and 15%. The 22(x) multiple is the largest premium for one of our financials, but when interest rates change, CME will benefit positively.
We are long a little bit of ICE, and are doing some homework on the CBOE. However, CME is by far our largest exchange holding.
Bank of America:
Still trading at a discount to tangible book value (TBV) of $13.50 per share, BAC is our tangential banking housing play. With all the litigation around BAC's purchase of Countrywide Financial, BAC will benefit two-fold as the litigation gets dissolved and settled, and the mortgage market and residential housing market recover.
Current EPS estimates for BAC are for $0.93 and $1.27 for 2013 and 2014, for expected year-over-year growth of 272% and 36%. At 10(x) current earnings, you aren't paying up for a strong recovery and a settlement of the housing issues. We think peak earnings for BAC are closer to $2 per share, which means that the bank should trade up to close to $20 at some point.
Some other favorites financials of ours that are pretty decent client holdings include Charles Schwab (SCHW), and Wells Fargo.
We would like to see better revenue growth in financials, and the overweight in the sector continues to be dependent on a national recovery in housing prices. With the homebuilder valuations and the complex accounting, we think the bank sector gives readers a better risk/reward as a housing play than many of the housing stocks.
What we worry about:
We would like to see more revenue growth for the sector, but it is gradually starting to build;
A Treasury market shock might favor the exchanges over the banks, and the bigger banks will weather the shock easier than the smaller or regional banks;
Continued improvement in housing sector fundamentals;
Stay with Financials. We think the group will continue to lead in 2013.