The stock market is a living, breathing organism, a dynamic maelstrom of economic influences that ebb and flow like waves on the open sea. Each sector of the stock market behaves in its own pattern that follows along the business cycle. Not all sectors perform equally, and understanding the current environment can lead to better investment decisions.
Right now, we appear to be teetering on the edge of a contraction phase. The long-lasting bull market has run out of steam with the collapse of China’s markets, which fed global expansion for years. Energy prices have fallen through the floor to multiyear lows, and positive economic data is scarce. One curve ball in this mixture is the beginning of a Fed rate hike that will likely lead to several more over the next year or so. Increased interest rates make one sector in particular stand out as a potential outperformer.
Singling out Financial Funds
One sector that’s primed to outperform right now is financials. Higher interest rates mean greater profits for banks and insurance companies. Post-financial crisis banks are stronger than ever as well. The big banks, such as Citi and BofA, are trading at levels last seen in 2011, and yet their balance sheets are the strongest seen in years. Stock prices in big banks could jump 20% or more, especially with interest rates on their way up.
Financial companies are in a great position right now to take advantage of rate hikes, with capital ratios at the highest levels seen in 80 years and solid earnings. The energy sector has been the biggest concern with distressed loans taking up a sizable amount of the banking industry’s resources. However, the latest information regarding fourth-quarter reports shows that exposure to the energy sector is easily manageable. In terms of exposure, oil and gas companies only account for about 1% to 3% of total loans, and banks have plenty of reserves set aside for potential losses.
One only needs to take a look at Warren Buffett’s position to see how strong the industry is right now. Wells Fargo, one of Buffett’s top picks, is a steal right now at just 11 times estimated 2016 earnings, with a dividend yield of 3% to boot. U.S. Bancorp is another Buffett favorite that’s putting up spectacular numbers.
The Bottom Line
Financial stocks are in a prime position to generate profits right now. Higher interest rates mean greater profit margins as long-term loan rates exceed short-term loans. If the Fed is to be believed, rates are only headed higher, which means that financial companies should profit. The business cycle might be at its peak with a downward spiral staring at us straight in the face, but the Fed is fighting against any downfall which could translate into a windfall for investors in financial companies.