Financial Stocks and Reversion to the Mean

If you are a believer in trends, and reversion to the mean, then you will find a recent report from Michael Hartnett of Merrill Lynch interesting.


Michael is the Chief Global Equity Strategist at Merrill, and I have found both his written work very interesting.

Here's what Michael wrote earlier this week (I have added the emphasis):

...almost all investment grade {bonds} and high yield sectors are at or close to all-time highs, as are defensive equity sectors such as health care and staples.  Many US asset prices are doing extremely well.  Even the investment grade bonds of the financials are at all-time highs. In stark contrast, despite a strong start to 2012, US financials stocks are 143% away from their 2007 all-time highs.

Restating Michael:  across the globe, asset prices have risen in tandem. Corporate bonds have soared, and investment grade yields are now at all-time lows.  High yield bonds have also moved sharply higher, and Merrill's high yield master index stands at a record high.

Most commodity prices are also much higher than a few years ago:  gold, copper, etc. have all climbed in price despite a deflationary environment.

Stocks, too, have mostly moved sharply higher from the lows in March 2009.  The S&P 500 now stands just 8% lower than its all-time high reached in October 2007.

But financial stocks have largely sat out the rally.

Despite a record divergence in valuation between financials and the rest of the market, investors are still wary of the group.  Low interest rates; weak loan demand; pending regulations; credit issues - all the problems of the financial group roll off the tongue like a liturgy at a Catholic Mass.

And yet:  financial history tells us that Reversion to the Mean is one of the most powerful forces in the capital markets.  When one group or asset class dramatically underperforms others, invariably the laggard will post strong returns relative to its peers to bring longer term results in line.

For example, in the 1990's, stocks dramatically outperformed bonds.  Many clients I worked with in 2000 were questioning why they owned any bonds at all, since stocks seemed to offer much more attractive returns.

We all know what happened next:  investors in corporate bonds in 2000 doubled their money in the next 10 years, while stock returns were essentially flat.

I could go on, but I think you get the idea.  Returns from asset classes tend to follow broad trend lines, and huge divergence from trends tend to be corrected, often fairly quickly.

The question is:  Is now the time for the financials?  Or have the fundamentals for the group been so dramatically altered that the stocks will never again reach the valuations of a few years ago?