ETF Trends
ETF Trends

In recent months, I’ve been advocating that investors focus on those market segments that are more reasonably priced with an emphasis on certain cyclical sectors. Six years after the 2008 financial crisis, there are a few cyclical sectors that seem to offer particularly good value. One is the financials sector.

Financial stocks, as represented by the S&P Global 1200 Financials index, are trading at a discount to the broader global market, when measured by both price-to-book and price-to-earnings valuation metrics.

Global banking stocks are currently valued at around 1.2x book value, trading at nearly a 40% discount to the broader global market. In price-to-earnings terms, the financials sector is trading at 14.8x trailing earnings, making it the lowest valued among the ten global sectors.

This, of course, leaves open the question of whether or not financials constitute a “value trap.” Many market watchers, for instance, argue that the sector’s lower valuations are merely a reflection of a drop in the sector’s return on assets (ROA) since the financial crisis. However, in reality, according to my team’s analysis, the sector’s ROA has recovered to a level not seen since the Bear Stearns collapse in early 2008, but valuations have not caught up.

In other words, unless you assume a much more dramatic collapse in ROA, when you consider the three forward-looking reasons below to like financials, there’s relative value to be found in the global sector, and particularly in its largest component: U.S. banks.

Financials are likely to benefit from rising rates. I expect that rates are likely to moderately rise from here and continue to increase in coming years, as the U.S. economy strengthens.

When rising rates are symptomatic of a strengthening economy, the financials sector’s performance and earnings outlook both tend to benefit as economic improvement leads to increasing demand for credit and higher yields on bank assets.

For instance, in J.P. Morgan’s 2013 annual report, released in April, the bank’s Chief Executive Office Jamie Dimon estimated that a return to higher, and more historically normal, rates could increase net interest margin by 2.2% to 2.7%, and boost the bank’s profits by $6 billion after-tax. This represents a 25% increase over the bank’s 2013 adjusted earnings after tax.

Solid loan growth should be a key contributor to higher net interest income for banks. One of the key themes that emerged from major U.S. banks’ second-quarter earnings reports is a notable pick-up in both consumer and, particularly, commercial loan volume. As economic growth continues to improve over the next year, loan volume should expand further, providing a tailwind to banks’ earnings.

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