Foggy Financials

Story Highlights:

• Financials stocks have lagged overall markets for nearly two years.
• Yet banks are healthy overall, with rising profits and sound balance sheets.
• Financials may continue lagging, but the sector doesn’t need to be robust for the broader market to do just fine.

Lately, investors have found a lot to bemoan (a sentiment we think is largely misplaced). Also on deck as a common recent frustration: Lagging Financials. Some fear if Financials don’t rebound soon, broader markets could be mired for some time.

Our view? It’s no surprise Financials are lagging. Following a sector-led bear market, investors typically punish the culprit. The sector usually gets a strong bounce off the bottom but lags relative to the broader market—sometimes for years. Remember Technology last decade? Though the market bottomed in late 2002, talk of new tech bubbles remained in 2005 and 2006. It was the same for Energy after its bubble burst in 1980. It’s just normal for investors to want to fight the last war.

That’s one issue. Another key issue is regulatory uncertainty still abounds. More regulations outlined in last year’s Dodd-Frank bill take effect next month, but several remain undefined. The 2,319-page bill passed with many, many vague directives, and Congress delegated much of the actual rule-writing to the Fed, Treasury and other bureaucracies. Legislators with no financial backgrounds deferring to “experts” may seem logical (on paper), but in reality it leaves many questions unanswered. Thus, here we are with 100 new derivatives rules about to kick in, and most aren’t drafted yet. It’s tough to know how a rule will impact profitability if the rule doesn’t exist.

More head-scratching came Tuesday when the Fed announced it backs a three percentage point surcharge on “big” banks’ capital ratios—mere months after banks passed stress tests with flying colors, and not one year since the US agreed to Basel III guidelines. Though “big” hasn’t yet been defined (unless you count the platitude “systemically important”), if the surcharge is followed, some firms could face capital requirements over 20% greater than Basel III. Maybe. Maybe not. Who knows? (See the problem here?)

Still, the market telling us it fears wonky regulation could impact banks’ future profit margins is a far cry from telling us banks are imperiled. In fact, banks today are pretty healthy. Banks’ return on equity and assets turned positive in 2010, and financial firms’ profits are up nearly 50% since 2010 began. Banks’ balance sheets are also far healthier than 2008, thanks to successful recapitalization, de-risking and improved asset quality.

And though Financials stock prices overall are lagging the broader market, they did bounce hugely off the March 2009 bottom. (Also typical of a sector that led a bear.) Global Financials were up around 150% in the first six months, more than twice the MSCI World. Tech also rallied hard in 2003 before middling from 2004 on, and the bull market kept climbing.

Can the market overall rise if Financials don’t participate? Of course—it already has. Financials have been flattish since September 2009 began, while the MSCI World is up more than 25% and the S&P 500 better than 30%. We don’t need a robust rebound in bank stock prices for the market to keep its swagger. We just need banks healthy and functioning, which they are. Sure, Financials will likely lag awhile—but they’re just one of the weaker sectors in a year when narrower equity categories likely vary more than usual.