What's On Tap..

Year to date the financial services sector has underperformed causing investors to avoid or under-weight it. Regulation is raising expenses and hurting profitability while low to negative global interest rates are weighing on net interest margins.  Some investors worry of another financial crisis that could send the sector into a tailspin similar to 2008/2009.

Through July 26th the financial sector is flat for the year while the S&P 500 is up more than 7%.  Over the last year the performance gap is even larger as financials are down nearly 4% while the S&P 500 is up more than 6%.  This underperformance has pushed the relative valuations of the financial sector versus the S&P 500 to its lowest levels in the last 10 years as shown in the chart below.

Source: FactSet

Source: FactSet

You don’t have to go back far to find a similar story of a sector weighed down by government regulation and concerns that profits will be constrained.  When the Affordable Care Act was announced in 2009 investors sold healthcare stocks and drove relative valuations to a level similar to where financials are today.

Source: FactSet

Source: FactSet

With low relative valuations, healthcare outperformed for four years afterwards as the Affordable Care Act was not the profit headwind that everyone had assumed.

Source: FactSet

Source: FactSet

While regulation has been an overhang to the financial services sector it has also been a blessing.  The tougher Basel III regulation along with the increased oversight from the Federal Reserve has strengthened the financial sector considerably since the 2008 crisis.  This strength was confirmed last month when the Federal Reserve released the findings of its annual stress tests evaluating the financial health of the largest banks.  The results were very strong as all but one U.S. bank had its capital plans approved by the Fed.  Since 2009, when the Fed began stress testing banks, banks have more than doubled their equity capital and are as strong as they have been in the last twenty years. 

Rates may be lower for longer but they won’t be lower forever and as the Fed normalizes rates this will help increase net interest margins for banks and drive income higher.  The strengthening economy should also steepen the yield curve, helping bank profitability.  With improving financial positions and very compelling valuations, investors may want to take this relative valuation opportunity to heart and consider overweighting financials. At Braver we have done so in both the Asset Allocation and Dividend Income portfolios.

 
  Charlie Toole, CFA, CFP Vice- President, Portfolio Manager

 

Charlie Toole, CFA, CFP

Vice- President, Portfolio Manager

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