At the start of the year, the financial sector outlook looked promising, with the Federal Reserve set on interest rate normalization and banks raising loan rates to capitalize on the rising rate environment.
However, as the Fed turns more dovish and banks continue to struggle, financial stocks and sector exchange traded funds may languish, heading into the first quarter earnings season.
Investors will begin to find some insight on the financial sector Wednesday when the earnings season kicks off with JPMorgan Chase (NYSE: JPM). Later on, Bank of America (NYSE: BAC) and Wells Fargo (NYSE: WFC) will report on Thursday, Citigroup (NYSE: C) on Friday, and Morgan Stanley (NYSE: MS) and Goldman Sachs Group (NYSE: GS) on Monday and Tuesday, respectively, next week.
The financial sector has been among the worst performing areas of the market this year as many market observers anticipate a steep decline in earnings. For instance, analysts project two-digit declines in average earnings form the big six U.S. banks, with some firms expected to report their worst quarterly results in over a decade.
Financial firms have been struggling to generate revenue after adopting costly regulations in the wake of the financial crisis and suffering through a low-rate environment.
For instance, capital-markets related income has dipped due to increased risk aversion and regulatory constraints. Bank returns are likely to remain depressed going forward as the industry adopts higher capital requirements and other regulatory restrictions.
Regulators have not completely reviewed the extent of the damage from the recession, and banks will likely need to keep up litigation costs to meet the greater scrutiny. More recently, Goldman Sachs footed a $5 billion bill to settle a federal and state probe into its mortgage-backed securities before the financial downturn, the latest among a myriad of fines that banks have issued, which weighed on previous quarterly profits from some of the major players.[related_stories]
Banks are also wading through an extended low-yield environment after the Fed cut its monetary policy outlook to two rate hikes later this year from previously expected four interest rate hikes. Even after tightening their belts, banks won’t find many more ways to cut expenses. The Feds slow rate hike policy will continue to put pressure on net interest margins for banks.
Consequently, traders are especially worried that this lackluster first quarter outlook for the financial sector could foreshadow a weak year ahead since banks typically make at least a third of their annual revenue in the first three months.
ETF investors can track the financial stocks and banks through a number of broad sector plays. For instance, the Financial Select Sector SPDR (NYSEArca: XLF), which tracks financial stocks taken from the S&P 500, holds a 33.3% tilt toward the banking sub-sector, including 7.9% WFC, 7.7% JPM, 4.9% BAC, 4.4% C, 2.2% GS and 1.3% MS.
For more targeted exposure to banks, the iShares U.S. Financial Services ETF (NYSEArca: IYG) has a 53.9% exposure to banks, including WFC 11.0%, JPM 10.8%, BAC 6.8%, C 6.2%, GS 3.0% and MS 1.9%.
Investors can also take a look at the more recently launched Financial services Select Sector SPDR Fund (NYSEArca: XLFS) in response to the new changes in the Global Industry Classification Standard, which will create a separate Real Estate Sector from the Financial Sector. XLFS will reflect the performance of the Financial Services Select Sector Index, which tracks areas like diversified financial services, insurance, banks, capital markets, consumer finance, thrifts, mortgage finance and mortgage REITs, excluding real estate investment trusts. The newer sector ETF also holds a hefty 34.0% tilt toward diversified banks, including WFC 9.8%, JPM 9.6%, BAC 6.0%, C 5.5%, GS 2.6% and MS 1.7%.
For even more targeted exposure, the PowerShares KBW Bank Portfolio (NYSEArca: KBWB) and SPDR S&P Bank ETF (NYSEArca: KBE) lean toward large banks. KBWB follows a market cap-weighted index, which make the index heavy on prominent banking names. KBE, on the other hand, tracks an equal-weight indexing methodology, so the ETF will include a greater tilt toward mid-cap banks. KBWB holds 8.1% C, 7.9% BAC, 7.9% JPM and 7.7% WFC. Meanwhile, KBE includes about a 2% tilt in C, BAC, JPM and WFC.
On the other hand, ETF investors who are worried about the upcoming financial earning season can also hedge the sector through various levels of leveraged inverse strategies. For instance, the ProShares Short Financials ETF (NYSEArca: SEF) takes the single inverse or -100% of financial stocks, while the ProShares UltraShort Financials (NYSEArca: SKF) takes a leveraged -200% of financials. Additionally, for the more aggressive bearish trader, the ProShares UltraPro Short Financials (NYSEArca: FINZ) and Direxion Daily Financial Bear 3X Shares (NYSEArca: FAZ) take the -3x or -300% performance of the financial sector.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.