The (Patient) Case for Overweighting Financials

Summary

• Financials P/E ratios are now about 60% of the S&P 500 versus a historical norm nearer 75-80%.
• For financials to outperform SPX, this valuation gap must narrow. That requires that the economy remains in growth mode, the ongoing rotation from growth to value continues, and the tech bubble keeps deflating.
• For now, the prognosis for all three is good. But risks abound, including geopolitical developments, a Fed policy error, or Congress and regulators failing to curb the tech sector.

Investment Implications

• Consider overweighting financials on expectations of returning to more normal valuation levels relative to SPX. We view this as a medium-term trade that may take time to perform.
• Be vigilant about risks and developments that could derail this strategy.

We recently argued financials, particularly banks, were unlikely to outperform in coming quarters due to the Fed raising rates. Our point was that banks at best performed in line with the S&P 500 during the past two Fed hiking episodes. Further, to the extent they did outperform, it was due to factors unrelated to Fed policy.

Still there is little question financials have lost ground to the S&P 500 over the past few years and appear relatively cheap (Charts 1 and 2). Looking at P/E ratios, financials were about 70-80% of the S&P 500 before the financial crisis. Since 2013, financial P/Es have been more variable but stayed roughly in that range. But beginning in 2019, the gap widened as the S&P 500 P/E soared from 20 to 30. SPX has since retreated to 23 – but financials gained little ground relatively. The gap did rise from roughly 55% to 58% during the early 2022 selloff, but financials gave up most of those gains after Western countries imposed severe financial sanctions on Russia. (We do not show financial P/Es between 2008 and 2012 because minimal earnings resulted in meaningless ratios.)

Source: Bloomberg, Macro Hive

We offer two takeaways. First, financials did not get cheaper since 2019.  Rather the S&P 500 got richer due to the tech-sector boom. Second, financials have always traded at a discount to the broader market.

For this analysis, we compare the S&P 500 (SPX) to several financial equity indices covering major and regional banks, insurance companies and the broad financial sector. We summarise these indices and tracking ETFs at the end of this article.

Financials Are Simply More Volatile

Financials trade at a discount to the broader market because they are riskier.

A standard measure of risk is the volatility of returns. We show a rolling one-year window of the standard deviation of daily returns for SPX and several financial indices (Chart 3). Clearly, during times of stress, financials are far more volatile than the SPX.

During the halcyon days between 2003 and 2008, there was little difference between the SPX and financials. But since, financials have consistently been at least slightly more volatile. Most recently, financial P/Es collapsed in 2Q 2020 when banks made large provisions for losses when the Covid pandemic hit. In this particular case those anticipated losses were never realised because of unprecedented strong fiscal support for the economy. Loss provisions were released back into earnings causing earnings to surge. This of course was an exceptional case. But volatility is volatility.

The key point is that financials are subject to a larger degree of volatility than the broader market, and all things equal, investors should require higher returns (or lower valuations) to compensate for that risk.

Source: Bloomberg, Macro Hive

That is even more interesting because some academics and regulators claimed that requiring banks to hold more capital after the financial crisis would result in more stable earnings and less volatile equity prices. As apparent from Chart 4, higher capital caused returns on equity to decline for financials after the financial crisis, from around 15% to under 10%.

But looking at equity performance during the selloffs in late 2018 and 1Q 2020, investors apparently did not get the memo (Table 1). Or more likely, they did, but they know sophistry when they hear it. For more capital does not mean banks will sustain fewer loan losses in a recession. It simply means there is less risk the taxpayer will have to bail out banks if loan losses are large. Reducing risk for taxpayers does not necessarily reduce risk for shareholders.

Source: Bloomberg, Macro Hive

Bottom Line

The bottom line here is that financials are riskier than the broader and more diversified SPX. That is unlikely to change.

Does Tech Return to Earth?

That said, could financial P/Es rise from 55-60% of SPX to as much as 75-80%? Doing back of the envelope calculations, that implies financials must rally by a third (so the broad financials index rises from 480 to 630). Or it implies the SPX must fall a third (from 4500 to 3000) – or some combination thereof.

How might that happen? First, the economy must stay in growth mode. If something (say a geopolitical development or a Fed policy error) pushes it to recession or near-zero growth, financials will most likely underperform SPX, and the valuation gap will widen. That said, financials usually outperform in the early stages of a recovery as the extent of loan losses becomes known. That presents opportunities for investors who were underweight financials entering the recession.

If the economy stays in growth mode, the recent rotation out of growth into value must continue. That would cause the tech component of the SPX to deflate and potentially make financials more attractive.

One way this appears to be happening is that investors are shedding profitless tech companies.

We do not think this is because these companies lack profits. Rather, it is due to rising regulatory pressure to curb FAANG tech companies and the growing likelihood that buying out emerging competitors or attractive new technologies will become much harder for large tech companies.

Indeed, many of those profitless tech companies have no intention of creating a profitable business model. Their strategy has been to pump up those metrics that make them attractive acquisition candidates. If that exit strategy is getting shut down, many of these companies will have to create a new business model. Until they do, they are essentially worthless. That suggests the tech selloff will continue.

Overweight Financials

All things considered, we think it currently makes sense to overweight financials. This is possible through ETFs (Table 2).

We have no strong view about subsectors as they tend to be highly correlated. Insurance earnings have been more volatile in recent years due to natural disasters, especially in 2017 when three major hurricanes (Harvey, Irma and Maria) hit the US. But insurance earnings also have pricing power to recover losses through higher premiums.

Regional banks have tended to be stronger performers than major banks, but also have more downside risk should there be an economic downturn. Alternatively, investors can hold a broad basket of financials. This is both more diversified and has exposure to profitable financial services companies such as American Express, Visa and Mastercard that other financial indices exclude.

We caution this is a medium-term trade. It may take several quarters or more to happen. And risks abound – including adverse geopolitical developments, a major Fed policy error, or Congress and regulators failing to curb the tech sector. Investors positioning for continued recovery need to monitor these risks closely.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)