Financial stocks have been a controversial sector since suffering massive losses in 2007-08, much like Tech stocks were following the bursting of that bubble in 2000. Financials have also generally been out of favor during the recovery of the last few years. In 2011, they were the worst performing sector in the S&P 500, and apart from a vicious two-month bounce off the bottom in 2009, they’ve been underperforming for years. In addition, they’ve been battling increasingly negative public opinion in regards to business practices (most of which is probably deserved, and largely self-inflicted).
But despite the losses in recent years, Financials are still the second largest sector in the S&P, and they can’t simply be ignored. In fact, Financials have actually been starting to join the party in the stock market. Since last October’s low, while the S&P has rallied an impressive 28%, Financials are well ahead of that pace, with a blistering 40% surge (as measured by XLF, a Financials ETF). On a relative basis, the trend in the sector has looked much more constructive lately than it has in a long time.
There have also been fundamental improvements taking place, too. Last week, the Federal Reserve released the results of another stress test of 19 systemically important financial institutions. While there are those who question the Fed’s methodology in conducting these tests, in this case, it’s hard to argue that it wasn’t “stressful” – in a hypothetical scenario of renewed economic weakness, they assumed the unemployment rate would climb back towards 13%, stock prices would collapse by 50%, and housing prices would fall by 21%. 15 of the 19 companies in the stress test passed, meaning that the Fed believes they would still have a reasonable capital cushion if such a negative scenario were to occur.
Financials probably aren’t out of the woods just yet. They’re adjusting to operating in an environment of increased scrutiny and regulation, and there will probably still be challenges that arise because of that. However, we believe there are enough signs of improvement amid very negative investor sentiment to begin to move away from being as underweight as we’ve been. Therefore, we’ve begun to reestablish some exposure to the Financials sector in recent weeks, primarily through an equal-weighted ETF of 40 large and medium sized banks throughout the U.S. (symbol: KBE).