Editor’s note: This column is part of our Best Stocks for 2014 contest. John Jagerson and Wade Hansen’s pick for the contest is the Financial SPDR (XLF).
While many investors are nervous that stock prices have climbed to unsustainable highs thanks to the quantitative easing program instituted by the Federal Reserve, we believe 2014 could be a banner year for financials for the following three reasons:
- Improvements in net interest margins
- General economic growth
- Increased dividends after 2014 stress tests
Let’s take a look.
Improvements in Net Interest Margin
While the FOMC has started “tapering” its QE program, the committee has made multiple reassurances to the market that it will leave short-term interest rates near zero for the foreseeable future.
At the same time, longer-term interest rates are rising. In the chart below, you can see that the yield on the 10-Year U.S. Treasury has risen to nearly 3% after having reached a low of about 1.63% in early May.
This widening spread between short-term interest rates and longer-term interest rates is positive for banks and other financials because it improves their net interest margins. That’s the spread that banks make when they collect higher interest rates from those they lend money to while at the same time paying lower interest rates to those who deposit money at the bank.
Paying 1% on savings accounts while charging 5% on loans is much more profitable than paying 1% on savings accounts while only being able to charge 3% on loans.
General Economic Growth
One of the reasons the FOMC has made the move to begin tapering its QE purchases is that the U.S. economy is continuing to grow and gather strength. But what many investors seem to have forgotten is that while tapering might reduce some of the bullish momentum in the stock market, a growing economy actually is a good thing for financials. The more the economy grows, the more business banks and other financial institutions are going to have as corporations continue to invest and expand.
Plus, while financial institutions may have some assets on their balance sheet that could take a small hit if Treasury prices continue to decline, they are more focused on trade volume. It doesn’t matter so much to them whether investors are trying to buy or sell Treasuries so long as they pay a commission every time they do.
Financial institutions that serve as primary dealers are in the enviable position of being able to generate fees whether the market is moving higher or lower.
Bigger Dividends After 2014 Stress Tests
Each year, the Fed conducts its Comprehensive Capital Analysis and Review — or “stress test” — in which it examines the financial strength of the major banks in the U.S. and assesses how each one would hold up under adverse economic conditions. In early 2014, the Fed is set to conduct its next CCAR, and we believe banks are going to pass with flying colors because of the capital positions they have built up.
You don’t have to look any further than the record level of nearly $2.4 trillion in Excess Reserves of Depository Institutions to know that banks are flush with cash (see chart below).
Having so much cash on hand should enable banks to easily clear the required thresholds to pass the stress tests, which will free them up to return a greater amount of cash to their shareholders in the form of dividends. The expectation of higher dividends should continue to push financial stocks higher.
To take advantage of each of these factors, we recommend buying a financial ETF.
Why You Should Buy the Financial SPDR (XLF)
When it comes to investing in a financial ETF, you have many available choices. You could buy the iShares U.S. Financials ETF (IYF), you could buy the RevenueShares Financials Sector ETF (RWW), or you could buy the Financial SPDR (XLF) — just to name a few.
So which one should you buy? For the Best Stocks of 2014 contest, we recommend buying XLF.
Why do we recommend XLF? Two words: “expense ratio.”
While various financial ETFs will have slightly different allocations within their portfolios — XLF is most heavily weighted in JPMorgan (JPM) and Wells Fargo (WFC) — they are all going to be similar enough so as to enjoy highly correlated performance (as you can see in the chart below).
However, just because two or three ETFs have similar holdings does not mean they will have similar expense ratios. Here’s the expense ratio breakdown for the three financial ETFs listed above:
- iShares U.S. Financials ETF (IYF): 0.45%
- RevenueShares Financials Sector Fund (RWW): 0.49%
- Financial SPDR (XLF): 0.18%
As you can see, XLF has an expense ratio that is less than half that of the other two funds. While this might seem like a small difference, it can add up over time. Plus, why would you ever want to pay more for virtually the same product? A penny saved is a penny earned.
We recommend new entries on XLF between $21 and $22. Our short-term target is $24, but for the Best Stocks of 2014 contest’s sake, long-term momentum could easily take the stock back toward $30 — the resistance level XLF dealt with from 2000 through 2005.
Otherwise, we recommend stop losses be placed under the lows XLF formed in late August and early October near $19.50. Looking outside the contest, options traders might look to buy longer-term at-the-money LEAPS with a conditional stop placed at the same price on the stock.
Wade Hansen and John Jagerson are the co-editors of SlingShot Trader. As of this writing, they did not hold a position in XLF.