C.J. Lawrence Weekly – Financials Sector is the Baby that Should be Put Back in the Bath

We made the point in a recent Weekly Market Comment that the shrinking US publicly traded company share count could be a contributing factor to the equity market’s long bull run. The same phenomenon can also contribute to stock price volatility on a short-term basis, as witnessed during the last two weeks of trading. As volatility returned to the market and sentiment shifted in both directions, the stock market’s gyrations became more pronounced. Human and electronic traders are using new tools to gain the immediate exposure they seek. When the market turns, all babies go out with the bathwater.

There are now around 4,000 publicly traded companies on major U.S. exchanges, and almost 2,000 equity ETF’s and ETN’s that own them. ETFs and ETNs now account for over 30% of daily dollar trading volume. Many of these funds own the same securities. When market sentiment shifts, as it did on February 2, with the release of better that expected average hourly earnings data (inflationary), those exchange traded products tend to be the first levers pulled. In the case of negative sentiment and selling activity, the fund sales can quickly overwhelm the markets of the individual underlying securities with sell orders, scare away natural buyers, and send the underlying share prices gapping down. As selling begets selling, corrections take shape. Several of the largest equity ETF’s experienced 2.5x-3.0x their average daily trading volumes between February 5 and February 9. Yet some of their largest holdings experienced only 1.2x-1.7x increases in average volume during the same period, suggesting that fund selling was likely dragging many underlying security stock prices along for the ride, without the corresponding increase in individual security trading volume.

For investors looking through a longer-term lens, these periods can expose attractive opportunities for long term accumulation. In the recent market downdraft, the S&P Financials Sector Index declined 11.3% from peak to trough (2/8/18). Meanwhile, 2018 earnings per share estimates for the sector have climbed 10% in just the last two months. The Index has regained 6% of its price decline but still trades at an attractive valuation. At 13.7x 2018 forecasted earnings per share, and 12.3x 2019 estimates, the S&P Financial Sector Index is priced at historically low multiples of earnings for periods of economic expansion. The low valuations come at a time when index constituents are experiencing double digit returns on equity, and improving net income margins. Inflation and interest rate related volatility is likely here to stay, and will continue to pressure P/E multiples on stocks. But at the same time, higher rates, a steepening yield curve, and an improving economy are constructive for financial shares. We continue to be overweight the sector and would be opportunistic in periods when market volatility throws out financial babies with the proverbial market bathwater.

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