Thursday, January 5, 2012

Investors Still Too Optimistic on Financial Sector

The problems of the financial sector are pretty well known.  Let me just talk about a few of them.

Low interest rates are killing the insurance companies.  Earning interest on the "float" - the difference in time from when premiums are received versus when claims are paid - are important part of industry profits.  When rates are as low as they are today, earnings will take a big hit.

Life insurance companies sold billions of annuity products to savers over the last few years offering returns of 5% or higher.  These were sold with the expectation that interest rates would move higher, but rates have confounded the "experts" and moved to 60-year lows.  Where are the insurance companies investing to earn their promised returns?

The flat shape of the US Treasury yield curves - especially on shorter maturities - makes it very difficult for banks to make money, especially when loan growth remains tepid.  Historically banks could take deposits and invest in Treasury notes if there was not sufficient loan demand, but the difference between deposit rates and Treasury yields has shrunk dramatically. You may think earning 0.5% on a 6-month CD is puny, but banks have few places to go to make any kind of spread.

Then there's the regulatory front. Although banks have become masters lobbyists, and have been very effective in blocking meaningful changes, the sentiment has definitely turned so anti-Wall Street which probably means that changes are coming.

For example, the so-called Volcker Rule (named after former Fed chair Paul Volcker) bans proprietary trading at investment banks. If the Volcker rule becomes effective, Brad Hintz of Sanford Bernstein estimates that Wall Street's fixed-income desks will experience a 25% decline in revenue and a 33% cut in pre-tax margins.

Oh, and discussions of stock transaction tax - now nicknamed the "Robin Hood Tax" - continue to gain momentum.  The idea is to charge a small tax (around 0.25%) on every stock trade, and use the proceeds to whittle down government debt.  Already the French and German governments have announced that they are in favor of such a tax, despite opposition from the UK and the US.  If enacted, imagine the impact on trading volumes if so-called high frequency trading is curtailed.

I could go on but I hope you get the idea.

So what are investors doing with this information?

Well, judging from where funds are being invested, the collective judgement of the market is that financials will be a good place to invest in 2012.

Here, for example, are the top five sector weights (by market cap) in the S&P 500 as of yesterday; notice what is the second-highest ranked:

Technology                           19%
Financials                             14%
Energy                                  12%
Health Care                          12%
Consumer Staples                 11%

Then there's more:  here's an excerpt from a note from the blog Zero Hedge:

Morgan Stanley {has calculated} that the relative contribution of financial stocks to the change in full S&P earnings (combined they account for 26.3% of the change from the actual $883.5 billion to $970.6 billion). Specifically we are looking at Bank of America, which with a forecast surge in Earnings from ($2.5) billion to $10 billion accounts for 14.1% of the entire change in S&P earnings forecasts. And since the S&P is simply the Earnings number multiplied by some multiple, all consensus views that have 1400 as their 2012 year end forecast rely on bank of America to account for nearly 20 S&P points!

The apparent discrepancy between fundamentals and market pricing will be an important area to watch in the financial sector in 2012, in my opinion.

And, unfortunately, fundamentals tend to win out over sentiment over time.