Pricey Financials in a Precarious Spot

ETF Trends

Second-quarter earnings season for the financial services sector is in full swing and while there have not been any epic disasters, at least not yet, from the marquee members of this sector, the group is not knocking the cover off the ball, either.

The Financial Select Sector SPDR (XLF) and the iShares U.S. Financials ETF (IYF) are each down 1% since the start of July, but some financial services ETFs have been noticeably worse than that, indicating there are pockets of weakness through the sector that is the second-largest in the S&P 500. [Bank ETFs Search for Momentum]

That weakness is appearing at a time when investors are moving toward late-cycle sectors such as energy away from early-cycle fare like financials. Adding to the issues facing bank stocks is the appearance of frothy valuations.

“Moving to the downgrade of financial services, the S&P 500 Financials sector is trading at a 22% premium to its median relative (to the S&P 500) 12-month historical operating P/E ratio over the past 20 years, more than pricing in an anticipated U.S. economic recovery. However, most companies’ operating results do not appear to us to be in recovery mode. The gnawing lack of solid, organic revenue growth is probably the largest issue facing this sector, forcing many firms to continue to grow EPS by cutting costs and buying back shares,” said S&P Capital IQ in a new research note.

ETFs such as XLF and IYF have been firm by comparison to more focused, less diversified financial services ETFs. For example, the iShares US Broker-Dealers ETF (IAI) is off 2.4% this month as several big-name capitals markets firms have reported slack second-quarter trading revenue, a situation that is expected to worsen in the current quarter on account of the summer doldrums and waning volatility. [Summer Blues for Broker-Dealers ETFs]

“For several years, bank revenues have been under pressure, as loan and investment security yields have fallen, driven by low market interest rates,” notes Erik Oja, an S&P Capital IQ equity analyst. “Banks have already reduced deposit and funding costs, however, so falling yields on loans and investments have already been a downdraft on net interest income for many quarters. Partly offsetting this is that net interest income and profits have caught a great tailwind from improving credit quality, which means more loans are able to pay interest.”

Although S&P Capital IQ has an overweight rating on XLF, the largest financial services ETF, the research firm advises a 14.7% weight to the sector. That is 135 basis points below the weight allocated to the sector in the SPDR S&P 500 ETF (SPY) . [Bank ETFs Face Headwinds]

XLF has added $630 million in new assets this year.

Financial Select Sector SPDR

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Tom Lydon’s clients own shares of SPY.

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