XLF: Time For Financial Sector To Catch Up
Summary
- SPDR Financial Sector ETF has drastically underperformed broader market in 2020 on weak earnings and plummeting interest rates.
- The banking sector is not facing a systemic crisis like in 2008 based on the TED spread.
- Many of XLF's top holdings are trading at deep discount with price-to-book ratios below one.
- XLF looks set to outperform the broader market on turnaround in value stocks and long-end bond yields.
After finally breaking through weeks of sideways consolidation, May turned out to be another banner month for major stock market indices, punctuated by the S&P 500 (SPY) recapturing the key 3000 level and 200-day moving average last week. Yet, the same cannot be said for the financial sector (NYSEARCA:XLF), which failed to take off and remains stuck under its April highs. In fact, the underperformance in XLF began prior to the coronavirus pandemic, and intensified during and after the crash:
Source: WingCapital Investments
Indeed, as we wrote prior to the coronavirus crisis taking hold, the inversion of the Treasury yield curve already telegraphed a rough year ahead for XLF. Specifically, we observed that XLF had begun lagging the SPY in mid-2007 soon after the yield curve inverted:
Source: U.S. Department of Treasury, WingCapital Investments
Conditions were ripe for a significant pullback in XLF and COVID-19 turned out to be the trigger, just as the subprime crisis started the onslaught back in 2007. Weak earnings have also justified the drastic underperformance in financials, which is one of several sectors with -30% or worse earnings growth rate according to Refinitiv:
S&P 500 Y/Y Earnings Growth Rates by Sector
Source: Refinitiv
Large increase in loan loss provisions has contributed to the sharp profit declines for the banking sector, which accounts for more than 30% of XLF's exposure. Meanwhile, top holding Berkshire Hathaway Inc. (BRK.B) (~14% weight) was hammered by the $55 billion loss in its stock portfolio. On aggregate, XLF's top 15 holdings' EPS growth declined by more than -15% and is expected to remain in the negative next year. On a more positive note, strong earnings from non-bank names, such as CME and ICE from the exchange sector, have helped limit the damage.
| Symbol | Name | % Weight | Revenue Growth (YoY) | Revenue Growth (FWD) | EPS Diluted Growth (YoY) | EPS Diluted Growth (FWD) |
| BRK.B | Berkshire Hathaway Inc. Class B | 13.79% | 2.70% | 5.11% | -62.38% | 2.37% |
| JPM | JPMorgan Chase & Co. | 11.31% | -2.38% | 0.66% | -4.00% | -2.19% |
| BAC | Bank of America Corp. | 7.39% | -7.51% | -1.99% | -8.55% | -5.79% |
| C | Citigroup Inc. | 3.88% | -2.07% | 0.02% | 5.85% | -3.32% |
| WFC | Wells Fargo & Co. | 3.75% | -9.93% | -4.49% | -36.06% | -14.93% |
| BLK | BlackRock Inc. | 3.15% | 6.75% | 2.06% | 1.78% | 3.19% |
| SPGI | S&P Global Inc. | 3.07% | 10.41% | 4.85% | 28.40% | 8.65% |
| CME | CME Group Inc. Class A | 2.58% | 18.81% | 6.88% | 24.58% | 3.11% |
| AXP | American Express Co. | 2.42% | 1.38% | 1.49% | -15.57% | -3.60% |
| GS | Goldman Sachs Group Inc. | 2.31% | 0.62% | -0.66% | -23.10% | -3.75% |
| CB | Chubb Ltd. | 2.14% | 3.72% | 4.34% | -4.92% | 4.97% |
| MMC | Marsh & McLennan Companies Inc. | 2.13% | 14.72% | 5.61% | 6.14% | 5.35% |
| ICE | Intercontinental Exchange Inc. | 2.10% | 9.40% | 5.52% | 7.02% | 8.88% |
| USB | U.S. Bancorp | 1.89% | -0.88% | 0.00% | -7.14% | -9.26% |
| MS | Morgan Stanley | 1.88% | 3.32% | -0.26% | 3.40% | -2.18% |
| XLF Top 15 | Weighted Average | 63.79% | 1.25% | 1.88% | -15.77% | -0.90% |
Source: WingCapital Investments
This Time Is Different For The Banking Sector
The surge in loan defaults certainly raises concerns of a replay of the subprime crisis, during which CDOs brought the banking sector to its knees in 2008. The TED spread, which is the difference between the three-month Treasury bill and the three-month U.S. LIBOR rate and a barometer of solvency risk in the financial system, had stayed elevated during the course of the bear market back then and spiked above 4% at the peak of the Great Financial Crisis:
Source: Federal Reserve Bank of St. Louis, WingCapital Investments
In contrast, this time around, the TED spread only briefly jumped above 1% in March before quickly receding to near zero. The resiliency of the banking sector can be attributed to the substantially more capital held by banks comparing to a decade ago. According to the Center for American Progress:
Between the first quarter of 2009 to the first quarter of 2017, the 34 largest bank holding companies increased their common equity capital-to-risk-weighted assets ratio from 5.5 percent to 12.5 percent.
Source: Federal Reserve Bank of St. Louis, WingCapital Investments
Not to mention the Fed came to the rescue with the unlimited QE and corporate bond ETF buying programs which immediately eased the liquidity strains in the financial system. As a result, major U.S. banks have been able to maintain their dividend payouts unlike in 2008. Among the top bank holdings in XLF, only Wells Fargo (WFC) is on the list of "potential dividend cut candidates" compiled by analysts at Keefe, Bruyette & Woods.
Value Stocks Showing Signs Of Life
One significant development in last month's breakout rally is that the gains were led by value stocks such as financials, which is a rare sight considering the years of domination by growth sectors that continued even during the pandemic. Indeed, as pointed out by Bloomberg:
On May 15, the Russell 1000 Growth index of U.S. large-caps moved to its greatest ever outperformance of the equivalent value index, narrowly beating the previous record from early 2000 when the dotcom bubble was about to pop.
Source: Bloomberg
Though, value stocks have since rebounded relative to growth, as XLF jumped 11% over the past 2 weeks while outperforming S&P 500 for a change. With valuations still in depressed levels based on the forward price-to-book ratio, which plunged to or below 1 for many of its top holdings, we reckon there remains plenty of upside potential for XLF.
Source: Seeking Alpha, WingCapital Investments
Long-End Yields Picking Up - Another Good Sign For XLF
The perpetual downtrend in long-term bond yields is another key factor behind XLF's decade-long underperformance. As the below chart shows, the XLF/SPY ratio tends to move opposite to the long-end Treasury bond ETF (TLT), with the latter recently launching to all-time highs after 30-year yields nosedived below 1%:
Source: WingCapital Investments
The good news for XLF is that the relentless rally in long-end Treasury bonds has finally shown signs of running out of steam as discussed in another article. As such, we expect XLF/SPY to rebound off its multi-decade lows alongside bond yields during the next leg higher in the stock market.
To conclude, after profoundly lagging the broader market for most of the year, the financial sector looks set to continue its resurgence this summer on a stabilizing economy, bargain valuations and bottoming of long-term bond yields. We expect the renewed rotation into value stocks to fuel the outperformance in XLF.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in XLF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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