Mean Reversion and Cheap Financial Stocks

Tuesday's surprisingly aggressive interest rate cuts by the Federal Reserve combined with the positive earnings announcement from Lehman Brothers (LEH) may be the catalyst needed to initiate a full fledged performance regression toward the mean in the financial services sector.

According to Morningstar, as of September 17th, Financial Services has been the worst performing market sector over the last month (-0.08), last three months (-6.10), and year to date (-0.56). In large part, this poor performance is due to the market wide credit crunch caused by securitized sub-prime mortgages. However, the interest rate cuts and Lehman Brothers positive earning announcement could be the signal investors have been waiting for...

First of all, Lehman's positive announcement could be a sign of positive things to come from other Investment Banks. Morgan Stanley (MS), Goldman Sachs (GS), and Bear Stearns (BSC) all announce earnings this week (editor's note: Morgan reported this morning), and Lehman's positive announcement has shed a little light on an otherwise dark group of stocks whose prices have been driven down by subprime fears. Certainly, there is no guarantee of similar positive news from the other investment banks, but Lehman's announcement may well signal we have turned the corner.

Secondly, the aggressive 50 basis point interest rate cuts by the Federal Reserve also bode well for Financial Services stocks. According to USA Today and Citi Investment Research, "typically, six months after a [50 basis point] Fed rate cut, consumer discretionary and financial stocks are the top two best-performing sectors." Also, according to Michael Farr, of Farr Miller & Washington, "speculators would quickly see a [50 basis point] rate cut as a signal of a trend of lower rates and scurry into areas hurt most by the credit crunch." Farr also says these areas include mortgage lenders and investment banks.

Certainly, there are no guarantees of Financial Services performance improvements. There are still many risks and unknowns. However, I'm seeing some good opportunities in the sector. On Monday, I made adjustments to overweight Financial Services in my own portfolio (I currently own five financial stocks which account for approximately 22% of my total portfolio).

Comments

[Uncle Bill]

Mark, where's the mean these stocks are reverting to? Is that as far as they'll go, back to the mean? Also, how do you figure your standard deviation and your mean? Finally, did you think these stocks would revert to the mean back in June? I'm interested in your approach -- this looks like good stuff.

[mark.d.hines]

Hi Bill,
The mean is the overall US Equity Market. No matter what proxy you use (Russell 3000, S&P500, etc), the Financial Services stocks have underperformed. They’ve been lagging pretty much all year (especially over the last three months).

I have been waiting for something in the market to initiate a regression toward the mean, and I think we may have gotten it on Tuesday via the Fed rate cuts and the better than expected earnings announcement from Lehman Brothers (Lehman has significant exposure to subprime credit markets, which has been the main source of fear that caused poor Financial Services performance in the first place).

I did not calculate the standard deviation, but you can do it easily by pulling historical data from Yahoo!Finance, pasting it into Excel, and using the statistics functions and data analysis toolpack.

I do think a lot of the financial stocks will make a strong run and outperform the overall market. Some of my favorites are Fortress Investment Group (FIG), the Blackstone Group (BX), and almost all of the bulge bracket investment banks (MER, GS, BSC, LEH, etc). You are welcome to continue the discussion, and check out all of my holdings at TheClearmarkFund.com.