Those Unloved Banks Look Lovable to Me

 You may have heard that financial services firms are unloved — and unloved everywhere around the globe.

Even among U.S. stocks — a refuge for investors from the turmoil in overseas stock markets since the 2008 financial crisis — financials look like The Forgotten Sector.

For example, financials are by far the most prominent sector in U.S. large-cap value indices, which is a collection of the cheapest U.S. stocks. They represent 23 percent of the S&P 500 Value Index and 24 percent of the Russell 1000 Value Index.

To put that unpopularity in perspective, consider that the next most represented sector in both those S&P and Russell indices is energy at 13 percent — and energy is in the throes of an historic meltdown.

Financials are also the most cheaply valued sector based on fundamentals, whether measured by assets or income. Financials in the S&P 500 trade at a price-to-earnings ratio of 13.8 (based on 12-month trailing earnings) and a price-to-book ratio of 1.1. The next cheapest sectors trade at a P/E ratio of 15.4 (telecom) and a P/B ratio of 1.9 (energy and utilities).

Reality is colliding with those valuations, however. Upbeatthird-quarter earnings from financial services heavyweights like JPMorgan, Citigroup, Bank of America, and most recently Goldman Sachs should put investors on notice.

Goldman’s fixed-income trading revenues for the third quarter — which blew past analysts’ estimates — have grabbed headlines. But all four banks also posted third-quarter revenue and income numbers that handily beat expectations.

And that’s just the beginning.

The S&P 500 Financials Index snapped a multi-year revenue drought in the third quarter. Revenue had barely budged from the second quarter of 2013 to the second quarter of 2016, with quarter-over-quarter revenue growth averaging just 0.4 percent during that stretch. But revenue was up 16.4 percent in the third quarter that just ended.

The sector’s third-quarter earnings results were no less dramatic. Earnings were up 16.6 percent over the prior quarter, on the heels of earnings growth of 10.1 percent in the second quarter. You have to go all the way back to 2009 to find back-to-back quarters of double-digit earnings growth for the sector.

It’s too early to say, of course, whether the third quarter’s results represent a turning point for U.S. financials, but there are signs that some investors are regaining confidence in the sector. The S&P 500 Financials Index has returned 23 percent since the year’s market low on February 11 through Monday (including dividends), while the S&P 500 has returned 18 percent over the same period.

All of this may have more significance to investors than they realize. That’s because many investors’ portfolios are tilted toward growth or value stocks, if not exclusively invested in one or the other. And given the wide valuation gap between financials and other sectors, it’s no exaggeration to say that a bet on value is a bet on financials and that a bet on growth is a bet against financials. While financials dominate the S&P 500 Value Index, they comprise just 3.5 percent of the S&P 500 Growth Index.

The outcome of that bet is likely to be more than just a rounding error. The S&P 500 Growth Index returned 8.4 percent annually from 2007 to 2015, while the S&P 500 Value Index returned half as much — just 4.2 percent annually — over the same period. It’s been just the opposite so far this year. The Value Index has returned 9.3 percent through September while the Growth Index has returned 6.4 percent.

It’s no coincidence that the S&P 500 Financials Index returned a negative 2.6 percent annually during growth’s win streak over value from 2007 to 2015, and that both financials and value are enjoying a resurgence this year.

Investors aren’t required to have an opinion about what’s next for financials, of course. But there’s a good chance that financials will have a say about what’s next for investors.

Source: Bloomberg Gadfly,