I started off wanting to write about how Consumer Staples and Utilities have taken out their April (and YTD) highs, which suggests the most conservative investors are buying stocks again (a leading indicator for the market, as I mentioned four weeks ago when I discussed a move to 1229-1250 on the S&P 500 in the next few months):
If cautious investors are afraid to buy stocks, how can we expect more aggressive ones to want to buy? In the last few weeks, equities have drawn investors. Specifically, look what's doing really well: Utilities, REITs, Consumer Staples
In reviewing several pieces of data, though, I was reminded of something that sticks out like a sore thumb (click to enlarge):
XLF, the ETF for the Financials in the S&P 500, is stuck in a basing pattern. The blue line up above shows that it has lagged the market by 10% since its peak on 4/14. In all fairness, that was preceded by a massive run-up (from 13.50 low in early February). Still, there aren't too many sectors that look like Financials. It was the only one to make a 52-week low during the summer's correction. Over the past six months, Financials have declined in price by almost 11%. The next closest sector is the sickly Healthcare group, down almost 4%. The winners, by the way, have been the two highest-yielding (but small) sectors: Telecom and Utilities.
Financials have been a pig for quite some time: Over the past three years, they are down in price by 59% (next worst is Telecom at down 35%). Over the past two years, they are the ONLY sector with a negative return (-2%). In fact, the next worst sector, Consumer Staples, is up 19% (Consumer Discretionary is winning at +55%).
Financials have a lot going against them:
- People are scared of them (rightly so!) - leverage
- They are very domestic in a market that likes international
- They are a big part of the market still despite the pounding (15.7%, second to Tech at 18.7% and well ahead of #3 Healthcare at 11.5%)
- High concentration - over 1/2 the market value is in just a few large names
Now that we have that out of the way, I think that there could be opportunity in the sector.
The chart above is from a recent peak, and it shows the sector has been basing. I would note that it is up 2% YTD. While this is lagging the broad market, which is up 4.5% on a price basis, it's really in line and not so bad given the terrible performance over the last six months. While it did make that nominal 52-week low during the summer, it looks now like it was just a shake-out. This has the look of something that will draw buying if it can clear 15.
The whole market is cheap, so I don't know that I can make the case that the Financial stocks are necessarily cheaper than the rest of the market. Looking at S&P's aggregation of earnings for 2011 by sector, the PE is 11 compared to the overall market at 12.4 (as of 10/5). There is a ton of compression - Industrials are the most expensive on this basis at 14X, while Energy is the cheapest at 10.5. We can debate this issue, but I think we can agree that the valuation isn't a barrier to advancement. Other metrics, such as P/B (or P/TB) are decent and certainly better than a few years ago (with lots of write-downs and obviously lower prices). My data source suggests that the average price to tangible book is just 1.7X. Checking a few large ones (in descending market cap):
- JP Morgan Chase (NYSE:JPM): 1.6
- Berkshire Hathaway (BRK/B): 2.2
- Wells Fargo (NYSE:WFC): 2.3
- Bank of America (NYSE:BAC): 1.3
- Citigroup (NYSE:C): 1.0
- Goldman Sachs (1.3)
I would make an additional argument: Credit-sensitive Financials have tremendous leverage. The curve is steep - if loan demand picks up and s.t. rates remain low, earnings will improve greatly. If s.t. rates rise, it's most likely because the economy will be doing better - lower credit losses. So, low PE and strong operating leverage. I am not sure if my data is correct, but according to Reuters, XLF earned $3 in 2007 roughly. There is a lot less competition today than then, though there is also lots more regulation. One final thought - when these guys start to jack their dividends again (and they will), it will draw in a whole new crowd. Of course, the stocks will already be way up by then!
A final observation about valuation, especially on the largest ones apparently. While the sector represents 15.7% of the market cap and 16% of the names, only JPMorgan Chase (JPM) is in the Top 10 of the S&P 500.
Risk-taking Is Cool Again
Investing in Financials, especially the big ones that make up more than 1/2 the market cap of the sector, with all sorts of businesses and lots of leverage, is inherently risky. It's too opaque for a lot of investors (including me, truthfully). Acknowledging the risk but taking into account the low valuation and the good chart action as described above, can we look to anything that says "jump in the water?" I think that emerging markets, many of which are making all-time highs (can you believe???), aren't a very good indicator - totally different bet. What about high-yield bonds, though? I think that these two animals are of the same species. Do we need to argue that point? If so, take it up in the comments below, but I think it's pretty obvious. There are two very actively traded ETFs for Junk Bonds: SPDR Barclay's High Yield Corporate Bond (NYSEARCA:JNK) and iShares iBoxx $ High Yield Corporate Bond (NYSEARCA:HYG). Their charts (click to enlarge) look similar, so I am going to go with JNK (because I like the symbol better) :
The point I am trying to make is that these two things, not surprisingly (since banks buy junk bonds simplistically), typically correlate well. It's not surprising in the "Yield Grab of 2010" that the interest-paying junk bonds are doing a bit better than the stocks of Financials with slashed dividends in this environment. I am not arguing that the stocks are a better bet (they may be) but rather that the love-fest for junk bonds, which are breaking to 2-year highs, is a potential tell. So are REITs, which are closer to home perhaps.
Another Tell: Decent Breadth
I believe that the overall sector is being dragged down by the big boys (the top 10 names out of a total of 78 Financials in the S&P 500). We can see this clearly in a number of stats:
- The market-cap return for the sector is 2%, but the average return is 8%
- 49 (63%) are up more than 2%
- Only 2 of the top 10 names are up this year, with 3 down more than 10%
So, the sector appears to be held back by a handful of the largest banks. The smaller Financials are doing very well. I didn't run the calculation of figuring out what XLF's return would be if we excluded the Top 5 several largest names, but it looks like the rest of the sector would be up more than the overall market. To check this, I looked at the index returns for Mid-Caps (S&P 400) and Small-Caps (S&P 600), and the Financials in those indices are up 8.9% and 7.7% respectively. While they are both lagging their respective indices (+11.7% YTD for the Mid-Caps and +10.5% for the Small-Caps), they are doing pretty well. Again, international exposure is clearly lacking. If one looks at what's working in the S&P 500 Financials, the highest YTD returns are in regional banks and REITs. Insurance companies, which don't tend to have as much leverage or credit risk are doing fairly well too.
Adding It All Up
It seems like all the signs are pointing to a big move in Financials. I have discussed some of the technicals, valuation and a few tells. I would note that the short-interest in individual names tends to be pretty small - the very large companies tend to have just 1% short-interest. A few names have low double-digit shorts relative to the float. XLF, in contrast, has a whopping 34% short-interest. I presume that after getting hosed by the SEC in 2008, hedge-funds prefer not to short individual names. OK, I have to confess, a lot of the SPDRs have very high short-interest - it's what the macro guys use. The size of the XLF is just $5 billion. I just wanted to see if you were paying attention. Micro-analysis aside, the low short-interest in the sector tells me that the shorts have given up. They have moved on to momentum stocks from what I can tell. The question now is when will the long-only money return, especially to the largest names.
I have to confess that I have very limited exposure in my models to the sector. In the Top 20 Model Portfolio, we are long only EZCORP (NASDAQ:EZPW). It is one of our largest positions, and we just added to it a week ago below 20. I think it can trade to 27 over the next year. I wrote about it in an article on the sector for TradeKing in July. If you care, I had a more detailed review last November. In the Conservative Growth/Balanced Model Portfolio, we are long just Cullen/Frost (NYSE:CFR). It's about as conservative as one can get - they took no TARP money. If you are interested, I wrote about it for TradeKing not too long ago. This one has been frustrating, up just 7% YTD. We owned it in Top 20 and sold as it approached 60 earlier this year. I think that I would buy XLF in that model now, but the fact that I refuse to even consider a stock like JPM in my "conservative" model tells me that I am probably looking too much in the rearview mirror. I wonder how long it will take for "conservative" investors to reembrace the leaders in the sector.
I smell a trade and probably a good investment too. I expect that a great many folks will think that I have gone bonkers. Let me know what you think!
Disclosure: Long EZPW and CFR in models at Invest By Model