Planning For Recovery: Financial Sub-Sector Relative Performance

The headlines have told us about the many bankruptcies, near bankruptcies and decimated share values in the financial company stocks — such as Countrywide (CFC), Northern Rock (NHRKF.PK), Washington Mutual (WM), and Bear Sterns (BSC). Among those that are not down for the count or on the ropes, much shareholder wealth has been lost.

Let’s look beyond to those that are still standing in terms of four sub-sectors: Large Banks, Regional Banks, Insurance, and Capital Markets (as represented by ETFs based on Keefe Bruyette & Woods indices).

The chart below shows the price performance of those four financial sub-sectors versus the total US stock market.

[click image to enlarge]

Large Banks and Capital Markets have done worse than Insurance and Regional Banks, but all have done badly relative to the total US stock market.

The Regional Banks and Insurance may or may not have future bad news to report. Neither is immune from liquidity and default risks that pervade the financial sector. They may not be on the front line of loss realization, which could make the nature and extend of their involvement in troubled assets less clear so far.

The table below shows some key portfolio statistics for the US total stock market and the four financial sub-sectors.

Individual Financial Stocks or Financial Stock Funds:

There is a continual debate within the industry about whether individual stock selection (taking “issue specific risk”) is a good idea for investors, and how many individual stocks are required to be effectively diversified — and about the potential disadvantages of buying an index which contains good, average and bad companies.

For most investors, we come down on the side of asset allocation through broad scope, passive index funds at the core of any portfolio with augmentation in targeted areas by narrow scope, passive index funds.

Whether you believe in a portfolio of individual stocks, a portfolio of active or passive funds, or a combination; we believe that the financial sector is not a great place to be attempting to cherry pick individual stocks this year.

Yes, we would agree with those of you who say that Bank of America (BAC) is a solid leader with a great dividend, but can you afford to take the shock if they announce a negative surprise? The lessons of Countrywide, Washington Mutual and Bear Stearns should be enough. We don’t put BAC in the same class with those unfortunate companies, but BAC is not necessarily exempt from big surprise announcements — none of the financials are exempt these days.

As we write, for example, Lehman (LEH) is off 38%, while SPDR KBW Capital Markets (KCE) is off a comparatively small 10%. Which would you rather own?

Morgan Stanley (MS) is off 12%, Merrill (MER) is off 10% and Goldman (GS) is off 8%. You are better off underweighting capital markets stocks today, but if you are in them you would probably sleep better with KCE than with any individual company. Nobody knows where the next shock will come from.

ETF Choices:

If you want to emphasize financials to position for a recovery, we strongly recommend a fund such as the Financial Sector SPDR (XLF). If you want more of a rifle shot, something like the sub-sector funds SPDR KBW Bank ETF (KBE), SPDR KBW Regional Banking ETF (KRE), SPDR KBW Insurance ETF (KIE), and KCE would be a better choice.

Be aware of liquidity and bid/ask spreads, however. KIE has poor liquidity, and does not trade continuously minute-to-minute.

KCE has moderate liquidity. KBE and KRE have good liquidity.

With any newer ETF, don’t invest before looking at the liquidity and spread “investability” factors — remember, that it may be easier to buy than to sell.

Bona fortuna!