People walk by a Citibank branch in New York January 17, 2012.SHANNON STAPLETON/Reuters
The U.S. financial sector has been flying high since the presidential election. The S&P 500 Financials Index is up 23.7 percent since Nov. 8 through Monday, outpacing the S&P 500 by 12.7 percentage points.
Some investors fear that the rally in financial stocks is overdone. Hedge funds have reduced their exposure to financials by 15 per cent since December.
It's not just ordinary profit-taking, however. Nine years into a historic U.S. bull market, investors are beginning to think about defence. And traditionally, financials are cyclical rather than defensive. In other words, investors expect financials to outperform the market during booms and underperform during busts. But that may be about to change.
Historical evidence undoubtedly backs up the cyclical argument. For example, when the S&P 500 tumbled 15.8 per cent from June to October 1990, the Financials Index was down 35.9 per cent. In the bull market that followed, the S&P 500 returned 16.8 per cent annually from November 1990 to March 2000, while financials returned 20.9 per cent annually. More recently, financials have outpaced the S&P 500 by 3.3 percentage points annually since March 2009 despite tighter regulation and lower lending rates.
Financial stocks' historical volatility, too, implies that they've taken investors on a bumpier ride than the broader market. The Financials Index has had a standard deviation of 21.5 percent since October 1989 -- the longest period for which numbers are available -- compared with 14.3 percent for the S&P 500. It's no accident that the big index providers such as FTSE Russell and MSCI include financial stocks in their cyclical rather than defensive indexes.
But past isn't necessarily prologue, and there's good reason to suspect that financials may resemble a defensive sector more than a cyclical one during the next market downturn. The characteristics that give sectors such as utilities and telecom their defensive powers -- cheap valuations and reliable earnings -- are now present in financial firms.
For one thing, financial stocks are still among the cheapest in the S&P 500 despite their meteoric rise. Financials boast the cheapest assets of any sector in the S&P 500, with a price-to-book ratio of 1.4 times compared with an average of 3.8 times for nonfinancial sectors. Their earnings and cash flows are also among the cheapest. The financial sector's price-to-earnings ratio is 16.8 times (based on 12-month trailing earnings), compared with an average of 32.2 times for the rest of the S&P 500. And their price-to-cash flow ratio is 11 times compared with an average of 13.2 times for other sectors. Only telecom's earnings and cash flows are cheaper.
Also, the 2008 financial crisis transformed the financial sector. Firms are more cautious and more regulated than they were. That's reflected in their lower and more stable earnings. And the Federal Reserve's eagerness to raise interest rates should finally give some lift to banks' profitability. Return on common equity for the Financials Index averaged 14.6 per cent from 1990 to 2007, but just 7.4 per cent since 2009. Higher profitability, of course, would further support stock prices.
It's tempting to assume that interest rates -- and by extension banks' profitability -- will turn south again during the next downturn, but that would just be a bias from the financial crisis. During the recession after the dot-com bust, financials' profitability averaged a healthy 14.8 per cent from 2000 to 2002, despite the fact that the Fed lowered the fed funds rate from 6.5 per cent in 2000 to 1.25 percent by the end of 2002.
It's also not obvious that lower interest rates will come to stock investors' rescue during the next downturn, as they did during the previous two sell-offs. The Fed has raised rates plenty of times while stock prices have dropped. For example, the S&P 500 tumbled 19 per cent from August 1956 to December 1957, when the fed funds rate climbed 0.25 percentage points. The S&P 500 was also down 32.9 per cent from December 1968 to June 1970, and the fed funds rate rose 1.75 percentage points. There are many other examples.
Investors have complained for eight years about how boring the financial sector has become. Those complaints may turn into cheers when the next market downturn comes along.
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Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.