Attractive Valuations Are Not Enough for Financial Sector ETFs

Bank stocks and financial sector-related exchange traded funds are among the more cheaply priced segments of the markets. However, the low valuations have not been enough to offset potential recession risks.

The Financial Select Sector SPDR (XLF) is trading at a price-to-earnings of 12.1 and a price-to-book of 1.1, with its book value near the lowest level since late 2020. In comparison, the S&P 500 Index shows a 16.5 P/E and a 3.0 P/B.

The S&P 500 bank index has also declined almost 25% in 2022, compared to the roughly 19% drop for the benchmark S&P 500.

Banks typically profit more in a rising interest rate environment. But investor shave so far has been trimming exposure to the sector on growing concerns that the Federal Reserve’s interest rate hikes to curb record-high inflation levels could trigger an economic recession. This would hurt loan growth and raise credit losses, Reuters reported.

“It really depends on your view of the economic outlook for 2022 and 2023,” Mike Cronin, investment director at asset manager abrdn, told Reuters. He also noted investors are starting to price in the risk of recession.

“If you look out past a recessionary scenario into 2024, there is some real potential upside in the group. We’re cautious on the near-term but seeing value in the long-term,” Cronin added.

Valuations For Banks

Investors will get a closer look into how Wall Street is faring as major banks begin reporting second-quarter earnings on Thursday. However, second-quarter profits at big banks are largely expected to decline due to increased bad loan reserves. Profits could also fall short in response to a dip in deals, although this could be partially offset by higher trading revenue from the recent volatile markets.

Michael Arone, Chief Investment Strategist at State Street Global Advisors, argued that bank stocks are inexpensive but warned of potential risks partly due to a slowdown in loan growth and inflation.

“Right now, the risks outweigh the opportunities… Earnings are going to be disappointing,” Arone told Reuters. “Outlooks are going to be very cautious.”

Arone added that bank executives could be betting on an improved mid- to long-term outlook.

“I don’t think you’ll see much talk about that,” Arone said. “They’ll want to under-promise and over-deliver.”

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