2 Financial Stocks for the Second Quarter

by Ivan Martchev | April 2, 2012 12:56 pm

The S&P 500 Index was up 12.59% in the first quarter, with banks coming in as the best-performing sector, up 21.46%. Naturally, the question arises: Should investors chase the Financial Select Sector SPDR (NYSE:XLF[1]) for the rest of the year, given that this great start in 2012 might signal this once-glorious group’s long-awaited comeback? My answer: not aggressively.

When I was asked to contribute a  story on the financials for an InvestorPlace special report[2] reviewing the first quarter and providing outlooks for the second, it was the equivalent of feeding a juicy T-bone to a hungry carnivore. But I prefer taking a top-down perspective because a bottom-up approach to big banks isn’t as productive now given the financial system’s current situation. Enterprising minds might want to click on the links to the relevant monetary [3]indicators[4] in the text.

As a matter of strategy, I believe long-term investors should avoid most large banks in developed markets. Many of these are good “trading” stocks — they go up for a few quarters at a time, and then those rallies tend to unwind. So, you can trade them, but you must be careful not to overstay your welcome. That’s because the record levels of financial system leverage in the developed world hit a wall in the Great Financial Crisis and have been coming down ever since.

In the U.S., total [5]debt [6]as [7]a [8]percentage[9] of [10]GDP[11] as measured by the Federal Reserve Flow of Funds Accounts has slid from 385.7% in the first quarter of 2009 to the present 354.7%.

The financial system is deleveraging despite the Fed’s pregnant [12]balance[13] sheet [14]and Washington’s deficit [15]spending[16]. Aggressive monetary and fiscal measures have not produced any sharp inflation as the M[17]1 [18]money [19]multiplier[20] — a measure of how fractional reserve banking in the U.S. creates systemwide credit — is plunging, as are the velocities of M[21]1[22] and M[23]2[24] money supply measures.

Think of this in the following way: Because money turns over more slowly and is being hoarded, you have to increase the quantity of excess reserves and seed credit in the system to keep the total amount of credit — the old M3 measure of money supply that is no longer reported but still can be extrapolated using current Fed data — from going down and creating deflation.

Financial system deleveraging isn’t good for the profits of large U.S. banks because lower levels of leverage can’t support asset prices accustomed to the previous higher level of financial leverage.

A simple recent, unfortunate example that applies here comes from the real estate market. You can buy a bigger more expensive house with zero down payment and an interest only-loan compared to the house you can buy with a 20% down payment and a conventional 30-year mortgage. That is, less leverage, less house.

It’s true that banks are lending to the real economy again as commercial[25] and [26]industrial [27]loans[28] in the U.S. are at $1.37 trillion and growing — a big positive in the current financial system conundrum. But the total amount of such loans outstanding is still way below the $1.6 trillion reached in October 2008.

Don’t get me wrong — there’s no[29] “[30]real[31]” [32]deflation[33] in the U.S. at present because this deleveraging shock has been countered by an exceptionally aggressive central bank. As of the time of this writing, bond investors are betting that the Fed will prevail in this monetary battle as 10-[34]Year [35]Treasury [36]Inflation[37]-[38]Indexed[39] Securities[40] (TIPS) yield a negative 11 basis points! By accepting negative yields on TIPS[41], investors are betting that the inflation indexing component will rise high enough so that their yields will grow substantially over the next 10 years.

Maybe bond investors will be right in their current TIPS bet because a busted credit intermediation system can be difficult to fix, as the Japanese example of Mitsubishi UFJ Financial Group (NYSE:MTU[42]), Mizuho Financial (NYSE:MFG[43]) and Nomura Holdings (NYSE:NMR[44]) shows. With the risk of oversimplifying the issue, think of those as the Japanese equivalents of JPMorgan Chase (NYSE:JPM[45]), Citigroup (NYSE:C[46]) and Morgan Stanley (NYSE:MS[47]), respectively, with the difference that the deleveraging shock in Japan did indeed turn into real[48] deflation[49] there[50].

Where to Look Instead

Still, because the U.S. financial sector is the world’s largest and most sophisticated, it does offer investing options that aren’t exposed to credit risk in the financial system. You can find companies that have better visibility of earnings in the current environment, like Visa (NYSE:V[51]) and MasterCard (NYSE:MA[52]). Both have no debt — a fact that investors who’ve looked at any bank’s balance sheet will greatly appreciate. Both have healthy operating margins of 52.26% and 60.18%, respectively.

MasterCard and Visa are also different because they’re more like technology companies that facilitate commerce and don’t worry about consumers’ ability to pay their credit cards bills — that’s the issuing banks’ problem (of course, they’re also vulnerable to bad publicity when hackers get hold of cardholder data[53]).

Only 15% of global retail transactions are done with credit or debit cards. This number is much higher in the U.S., at 48%, but there’s still lots of room for growth both at home and abroad. Visa now controls 39% of U.S. credit card volume, while MasterCard controls 23%.

Still, the environment is virtually the same for both companies, as valuation and recent performance typically become the factors to consider more seriously for choosing either V or MA from a shorter-term perspective.

Electronic transactions are likely to keep increasing in popularity, especially in faster-growing emerging markets with lower penetration rates. In 2011, worldwide spending on MasterCard- and Maestro-branded cards rose 16% to $863 billion, and spending by consumers outside their home countries climbed 18%. Outrageous, barely legal bid/ask spreads at foreign-exchange bureaus in airports are no longer an issue because MasterCard FX transactions are now done using market rates, increasing the appeal of using plastic abroad.

New regulatory developments in 2011 have leveled the playing field between Visa and MasterCard (issuing banks can can no longer force merchants to use one or the other). MasterCard’s management has decided that the business has enough cash-generating capacity to double the quarterly dividend to 30 cents a share. The annual dividend is small in percentage terms given the share price, but so is the single-digit payout ratio, indicating that in time the dividend has room to go higher.

Due to the settlement of a litigation issue, MasterCard’s 2011 profits grew only 3%. But given the 21% surge in net revenuesto $6.71 billion, its overall earnings picture is healthy. For 2012 and 2013, management is looking at a compound annual growth rate of 12% to 14% for revenues and a 20% rate for earnings per share.

Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates holds positions in the Financial SPDR (XLF), Mizuho Financial, MasterCard, and Visa for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities.

Endnotes:
  1. XLF: http://studio-5.financialcontent.com/investplace/quote?Symbol=XLF
  2. InvestorPlace special report: http://investorplace.com/hot-topics/quarterly-review-outlook/
  3. monetary : http://research.stlouisfed.org/publications/mt/
  4. indicators: http://research.stlouisfed.org/publications/mt/
  5. total : http://ycharts.com/indicators/us_total_debt_gdp
  6. debt : http://ycharts.com/indicators/us_total_debt_gdp
  7. as : http://ycharts.com/indicators/us_total_debt_gdp
  8. a : http://ycharts.com/indicators/us_total_debt_gdp
  9. percentage: http://ycharts.com/indicators/us_total_debt_gdp
  10. of : http://ycharts.com/indicators/us_total_debt_gdp
  11. GDP: http://ycharts.com/indicators/us_total_debt_gdp
  12. pregnant : http://research.stlouisfed.org/fred2/series/TREAST
  13. balance: http://research.stlouisfed.org/fred2/series/TREAST
  14. sheet : http://research.stlouisfed.org/fred2/series/TREAST
  15. deficit : http://research.stlouisfed.org/fred2/series/GFDEBTN
  16. spending: http://research.stlouisfed.org/fred2/series/GFDEBTN
  17. M: http://research.stlouisfed.org/fred2/series/MULT
  18. 1 : http://research.stlouisfed.org/fred2/series/MULT
  19. money : http://research.stlouisfed.org/fred2/series/MULT
  20. multiplier: http://research.stlouisfed.org/fred2/series/MULT
  21. M: http://research.stlouisfed.org/fred2/series/M1V
  22. 1: http://research.stlouisfed.org/fred2/series/M1V
  23. M: http://research.stlouisfed.org/fred2/series/M2V
  24. 2: http://research.stlouisfed.org/fred2/series/M2V
  25. commercial: http://research.stlouisfed.org/fred2/series/BUSLOANS
  26. and : http://research.stlouisfed.org/fred2/series/BUSLOANS
  27. industrial : http://research.stlouisfed.org/fred2/series/BUSLOANS
  28. loans: http://research.stlouisfed.org/fred2/series/BUSLOANS
  29. no: http://research.stlouisfed.org/fred2/graph/fredgraph.png?height=600&width=1000&id=CPIAUCSL&scale=Left&range=Max&cosd=1947-01-01&coed=2012-02-01&line_color=#0000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=3&ost=-99999&oet=99999&mma=0&fml=a&fq=Monthly&fam=avg&fgst=lin&transformation=pc1&vintage_date=2012-03-29&revision_date=2012-03-29
  30. “: http://research.stlouisfed.org/fred2/graph/fredgraph.png?height=600&width=1000&id=CPIAUCSL&scale=Left&range=Max&cosd=1947-01-01&coed=2012-02-01&line_color=#0000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=3&ost=-99999&oet=99999&mma=0&fml=a&fq=Monthly&fam=avg&fgst=lin&transformation=pc1&vintage_date=2012-03-29&revision_date=2012-03-29
  31. real: http://research.stlouisfed.org/fred2/graph/fredgraph.png?height=600&width=1000&id=CPIAUCSL&scale=Left&range=Max&cosd=1947-01-01&coed=2012-02-01&line_color=#0000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=3&ost=-99999&oet=99999&mma=0&fml=a&fq=Monthly&fam=avg&fgst=lin&transformation=pc1&vintage_date=2012-03-29&revision_date=2012-03-29
  32. ” : http://research.stlouisfed.org/fred2/graph/fredgraph.png?height=600&width=1000&id=CPIAUCSL&scale=Left&range=Max&cosd=1947-01-01&coed=2012-02-01&line_color=#0000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=3&ost=-99999&oet=99999&mma=0&fml=a&fq=Monthly&fam=avg&fgst=lin&transformation=pc1&vintage_date=2012-03-29&revision_date=2012-03-29
  33. deflation: http://research.stlouisfed.org/fred2/graph/fredgraph.png?height=600&width=1000&id=CPIAUCSL&scale=Left&range=Max&cosd=1947-01-01&coed=2012-02-01&line_color=#0000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=3&ost=-99999&oet=99999&mma=0&fml=a&fq=Monthly&fam=avg&fgst=lin&transformation=pc1&vintage_date=2012-03-29&revision_date=2012-03-29
  34. 10-: http://research.stlouisfed.org/fred2/series/DFII10
  35. Year : http://research.stlouisfed.org/fred2/series/DFII10
  36. Treasury : http://research.stlouisfed.org/fred2/series/DFII10
  37. Inflation: http://research.stlouisfed.org/fred2/series/DFII10
  38. -: http://research.stlouisfed.org/fred2/series/DFII10
  39. Indexed: http://research.stlouisfed.org/fred2/series/DFII10
  40. Securities: http://research.stlouisfed.org/fred2/series/DFII10
  41. negative yields on TIPS: http://investorplace.com/2012/03/dont-thumb-your-nose-at-low-yield-tips/
  42. MTU: http://studio-5.financialcontent.com/investplace/quote?Symbol=MTU
  43. MFG: http://studio-5.financialcontent.com/investplace/quote?Symbol=MFG
  44. NMR: http://studio-5.financialcontent.com/investplace/quote?Symbol=NMR
  45. JPM: http://studio-5.financialcontent.com/investplace/quote?Symbol=JPM
  46. C: http://studio-5.financialcontent.com/investplace/quote?Symbol=C
  47. MS: http://studio-5.financialcontent.com/investplace/quote?Symbol=MS
  48. real: http://research.stlouisfed.org/fred2/graph/fredgraph.png?height=600&width=1000&id=JPNCPIALLMINMEI&scale=Left&range=Max&cosd=1960-01-01&coed=2012-01-01&line_color=#0000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=3&ost=-99999&oet=99999&mma=0&fml=a&fq=Monthly&fam=avg&fgst=lin&transformation=pc1&vintage_date=2012-03-29&revision_date=2012-03-29
  49. deflation: http://research.stlouisfed.org/fred2/graph/fredgraph.png?height=600&width=1000&id=JPNCPIALLMINMEI&scale=Left&range=Max&cosd=1960-01-01&coed=2012-01-01&line_color=#0000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=3&ost=-99999&oet=99999&mma=0&fml=a&fq=Monthly&fam=avg&fgst=lin&transformation=pc1&vintage_date=2012-03-29&revision_date=2012-03-29
  50. there: http://research.stlouisfed.org/fred2/graph/fredgraph.png?height=600&width=1000&id=JPNCPIALLMINMEI&scale=Left&range=Max&cosd=1960-01-01&coed=2012-01-01&line_color=#0000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=3&ost=-99999&oet=99999&mma=0&fml=a&fq=Monthly&fam=avg&fgst=lin&transformation=pc1&vintage_date=2012-03-29&revision_date=2012-03-29
  51. V: http://studio-5.financialcontent.com/investplace/quote?Symbol=V
  52. MA: http://studio-5.financialcontent.com/investplace/quote?Symbol=MA
  53. hackers get hold of cardholder data: http://money.cnn.com/2012/03/30/technology/credit-card-data-breach/index.htm

Source URL: http://investorplace.com/2012/04/2-financial-stocks-for-the-second-quarter/
Short URL: http://invstplc.com/1nxukhd