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.
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.
With low relative valuations, healthcare outperformed for four years afterwards as the Affordable Care Act was not the profit headwind that everyone had assumed.
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.
IMPORTANT INFORMATION: This material is for information purposes only. The views expressed are those of the author(s) as of the date noted and not necessarily of the Firm and are subject to change based on market or other conditions without notice. The information should not be construed as investment advice or a recommendation to buy or sell any security or investment product. It does not take into account an investor's particular objectives, risk tolerance, tax status, investment horizon, or other potential limitations. All material has been obtained from sources believed to be reliable, but the accuracy cannot be guaranteed. We do not seek to endorse any investment products or financial services described herein. Any information about a product or service should be confirmed with its sponsor. Any remote links herein are provided only for your convenience and Braver Capital has no interest in, responsibility for, or control of the information on the linked website. We make no promises or warranties, expressed nor implied, including the accuracy of and fitness for a particular purpose of the content on any linked website. In no way will Braver Capital be liable for any damages resulting from use of these links under any circumstances.