A Closer Look at Financials

Following a big sector-led bear market (like 2008), the sector that led down usually bounces back big, then lags—often for years—as investors “fight the last war.”

That’s just what we’ve seen with Financials since the March 2009 bottom, as shown in Exhibit 1. Since the 2009 broad market bottom, there have been sporadic bursts of Financials outperformance, but much more frequent and consistent underperformance.

Exhibit 1: World Financials Relative Performance (Indexed to 1 vs. MSCI World)

Source: Thomson Reuters, as of 3/19/2012.

But this is a backward-looking reflection. What’s important for investors now is determining their expectations for forward-looking performance—for Financials or any sector. From that perspective, Financials faces some potentially positive and negative factors. Here are some considerations:

Potential positives:

• Asset and overall balance sheet quality have largely seen noticeable improvement.
• Importantly, asset growth hasn’t slowed—meaning the additional assets in the banking system are of overall higher quality.
• Financials firms overall are very well capitalized and are no longer increasing their capital ratios—capital is more willingly being deployed, rather than seemingly hoarded.
• Valuations are low—which isn’t surprising—but fundamental and broad economic improvements seem to have the sector poised for upward valuation creep.

Potential Negatives:

• Financials’ fundamentals have shown consistent improvement, but they aren’t yet back to pre-bear market levels of asset quality and growth.
• There’s much yet to be determined relative to Dodd-Frank and other possible bank-targeting legislation globally.
• From a sentiment perspective, investors still seem quite wary of bidding up Financials’ valuations significantly, at least in the near future.

Weighing potential positives against negatives is critical when forming forward-looking expectations for the sector.