Financial Stocks: A Winning Bet for Fed Tapering

Fundamentals, valuations, and rate sensitivity all point to 2014 outperformance

Financial Stocks: A Winning Bet for Fed Tapering

Financial stocks are at their highest level in five years, but more upside could be in store if the Federal Reserve indeed tapers its quantitative easing policy in the next six to twelve months.

Financial stocks are uniquely positioned to benefit from a tapering scenario. A reduction in quantitative easing, in conjunction with a continuation of the near-zero fed funds rate through 2016, virtually guarantees a steeper yield curve (causing long rates to rise while short rates stay flat). A steeper yield curve is a major plus for banks because it boosts their net interest margins. It also provides a tailwind for certain insurance companies by allowing them to earn a higher rate on their investments.

This dynamic is reflected in financials’ strong performance during the two intervals in which Treasury yields have moved higher. In the first — April 30 through August 31 — the Financial SPDR (XLF) rose 3.96%, outpacing the 3.03% gain of the SPDR S&P 500 ETF (SPY). In the second — October 31 through Thursday, November 21 — XLF has tacked on 4.5% and strongly outpaced the 2.34% gain for SPY.

xlf Financial Stocks: A Winning Bet for Fed Tapering

While this headline return is positive, a closer look at the financial sector shows that certain areas have performed much better than others. The table below shows that large-cap banks, as a group, delivered robust returns during the two periods of rising rates. Of the ten shown, four — Bank of America (BAC), US Bancorp (USB), Bank of New York Mellon (BK), and SunTrust Banks (STI) — outperformed the broader group in both intervals.

Stock Ticker Return, 4/30-8/31 Return, 10/31-11/21
JP Morgan JPM 3.9% 11.0%
Wells Fargo WFC 9.8% 4.0%
Bank of America BAC 14.8% 11.6%
Citigroup C 3.6% 6.1%
US Bancorp USB 9.3% 4.0%
PNC Financial Services PNC 7.1% 3.8%
Bank of New York Mellon BK 5.9% 6.0%
State Street STT 14.6% 2.8%
BB&T BBT 11.9% 1.9%
SunTrust Banks STI 10.2% 6.6%
AVERAGE 9.1% 5.8%
Financial SPDR XLF 4.4% 4.0%
S&P 500 ETF SPY 3.0% 2.3%

But banks aren’t the only ones who benefit from rising yields…

Insurance companies, as a group, have also been winners at the times of rising yields, with MetLife (MET), Prudential Financial (PRU), and Marsh & McLennan (MMC) among those that have outperformed in both periods:

STOCK Ticker Return, 4/30-8/31 Return, 10/31-11/21
MetLife MET 20.0% 12.6%
Prudential PRU 25.3% 10.8%
Marsh & McLennan MMC 9.1% 4.3%

Outside of these two areas, the results have been mixed. On the plus side, Morgan Stanley (MS) and Charles Schwab (SCHW), and Interactive Brokers Group (IBKR) have all been among the big winners.

On the other side of the ledger, real-estate investment trusts have lagged considerably. The iShares U.S. Real Estate ETF (IYR) took it on the chin in the May-August period, falling 14.5%, and again in November, with a loss of 3.8%. Investment managers, which typically do well when the stock market is rising, have underperformed the broader financial sector by a wide margin while rates have been backing up:

Stock Ticker Return, 4/30-8/31 Return, 10/31-11/21
BlackRock BLK -1.1% 0.9%
T. Rowe Price Group TROW -2.8% 3.9%
Franklin Resources BEN -10.3% 1.2%
Invesco IVZ -3.0% 0.8%

This performance data helps provide investors with a playbook for any tapering scenario that may occur in 2014. While opinions vary widely on this issue, the consensus (for now) is that the Fed will indeed begin to cut back on its asset purchases in the coming year. Assuming that rates will continue to rise on the news, financials in general — and banks and insurance companies in particular — look poised for continued outperformance as long as their fundamentals remain intact.

These groups also provide investors with a way to make a play on the long-anticipated bond bear market. While the option always exists to buy an inverse ETF or trade options on funds such as iShares 20+ Year Treasury Bond ETF (TLT), a long position in financials also represents a bet against bonds — but with extra beta and the added benefit of the generally positive outlook for financials.

According to Factset, S&P 500 financial companies are trading at 12.6 times forward earnings — the lowest of any sector and a deep discount to the 15.1x forward price-to-earnings ratio for the index as a whole. Despite this year’s 32% rally in financials, this 16.6% discount to the broader market is larger than the 15% average discount at which financials have traded in the past ten years.

At the same time, financials are expected to generate 11.5% earnings growth in 2014, better than the 10.9% of the broader market. Estimates have actually risen from 9.3% on September 30 even as overall S&P 500 estimates have fallen slightly. Of the ten major sectors, only energy has seen its estimates rise in the past seven weeks — all others are down.

The Bottom Line

Financial have rewarded investors with big year-to-date returns, but the sector remains a hedge against rising bond yields and the re-emergence of tapering-related volatility. Look for continued upside for financials in 2014.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2013/11/financial-stocks-winning-bet-fed-tapering/.

©2014 InvestorPlace Media, LLC

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