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A Bullish View On A Downtrodden Financial Services ETF

ETF Professor

Declining interest rates and increasing speculation that the economy is slowing are among the factors pressuring financial services exchange traded funds. Down almost 3.5% over the past month, the Financial Select Sector SPDR (NYSE: XLF) epitomizes those struggles.

What Happened

While the S&P 500's third-largest sector weight is scuffling, some analysts believe there is upside to be had with the financial services sector, a group almost universally viewed as a value destination.

In a note out Tuesday, AltaVista Research tagged XLF with an Overweight rating. That rating is not to be taken lightly for the sheer fact that the research firm rates each of the 11 sector SPDR ETFs and only has one other Overweight rating besides XLF – the Health Care Select Sector SPDR (NYSE: XLV).

Why It's Important

XLF's Overweight status implies above average appreciation potential, according to AltaVista. That appreciation, assuming it can be accrued, will have to arrive against a backdrop of massive investor departures from XLF. In the first two months of the third quarter, the ETF has bled $2.56 billion in assets.

Regarding the Overweight rating on XLF, AltaVista said, “typically, funds in this category consist of stocks trading at attractive valuations and/or having above-average fundamentals.”

While low valuations, increasing dividends and expanded buyback programs are seen as benefits for bank stocks, those factors are largely baked into share prices, but additional interest rate cuts, which weigh on net interest margins, are not fully priced into XLF and its components.

Additionally, if economic data continues to deteriorate, investors may pass that trend over to banks, assuming that as conditions worsen, creditors will rein in lending activity.

What's Next

XLF's payout ratio is just 27.2%, indicating plenty of room for dividend growth, and at just 11.4 times next year's earnings, the sector is undoubtedly inexpensive.

“Profits rose smartly in 2018 on the tax cuts, higher interest rates and regulatory relief, resulting in a move to higher margins and ROE, which forecasts for 2019-20E suggest will be sustainable,” said AltaVista. “But a slowing economy with an inverted yield curve are a less-than-ideal environment for Financials, and sell-side analysts relative pessimism on the sector reflects this. Nonetheless with valuations at the lower end of their historical range, Financials look quite attractive.”

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