Top 10 trade ideas for 2014 – Proposition #2: Financials
The outlook for equities remains positive for the months ahead and well into 2015. While past seasonal patterns have been difficult to read and market performance unpredictable for a number of quarters, it can now be assumed that central bank policy is well established enough to prevent the economy crashing or overheating anytime soon.
In recent years, the financial sector has underperformed for obvious reasons, not least due to the introduction of new policies and regulations. Banks presently trade on a FY3 P/E discount of about 20% to the market, based on the fact that risks are lower than in the past and the potential for earnings upside corrections more likely. In the insurance sector, the FY1 P/E is showing nearly a 30% discount to the market. This sector will benefit particularly well from rising (constant) bond yields which make their long-term savings products more attractive.
In general, the financial sector is one of the key beneficiaries from better economic conditions. Further improvements as the US and European markets exit recession are expected to further benefit investments. Finally, profitability is further supported as a result of narrowing bond yields and credit default swap (CDS) spreads.
Normally, broad-based financial companies are not considered cyclical stocks; however, they are behaving like cyclical stocks at present. Most of the stocks in the financial sector have a beta in the 1st quartile.
List of attractively valued financials (alphabetical order):
Investment Proposition 2014 Financials.pdf
Downside
After three years with almost no economic growth in Europe, profits either need to increase as expected, or if not, the European economic situation will deteriorate and will impact the health of the world economy.
Furthermore, the recovery of the broader financial sector depends on gradually rising bond yields (no spikes) and additionally on a rising risk premium in the bond market. The spiking of bond yields could be due to inappropriate Fed tapering.
A rise in the overall unit production cost could push up inflation expectations, which in turn could be a sharp driver for equity downside correction as a result of lower growth rates and lower EPS margins.
The overall equity market valuation has risen during the last quarter while at present ERP figures remain relatively high. Decreasing ERP, all things equal, would result in relative market consolidation.