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Can Financials Keep Setting the Pace?


The biggest winners have been the most beaten-down stocks during the financial crisis. Of course, these companies also had the most to recover from.

I don't like to be wishy-washy – but the case to play the financials is a little muddy. I follow this sector closely because I have spent two decades working in it. The recent sector performance has been impressive. How to play it next is a little confusing. Let's start with the numbers.

Financials are up 24% over the last three months. Just look at the Financial Select Sector SPDR (XLF). Financials are most certainly, however, still the big loser for the last 52 weeks – down almost 12%. Added to that, financials are far and away the biggest losers since the market crisis of 2008. The XLF is down more than 45% from its January 1, 2008, levels.

Every other SPDR sector ETF (with the exception of the Utilities Select (XLU)) is either positive or within striking distance of its price compared to January 1, 2008. So, let's look away from price action and look at value. Looking at the price-to-earnings ratios for these sectors might be instructive.

The XLF still hovers around a 10 times P/E ratio. This is a historically low number for financials – but then again, financials will never trade at their historical P/E ratio again. Nor will they be returning to the pre-crash levels of earnings any time soon. The extreme leverage is gone from their balance sheets – and Washington, DC, is committed to keeping their earnings in line with what is "fair" (whatever that means).

So, how do we figure out if financials are still trading at a discount – despite the fast move up over the last three months? Let's look at which financials companies are driving the move upward.

The biggest winners have been the most beaten-down stocks during the financial crisis. Of course, these companies had the most to recover from being so beaten downward.

The biggest winners of the last three months that are really driving the sector upward: Citi (C) (+26.1%), Bank of America (BAC) (+38.19%), Goldman Sachs (GS) (+25.2%), AIG (AIG) (+27.25%), and Morgan Stanley (MS) (+33.7%).

These five firms are among the top 12 largest financial firms by market cap. All of these firms have been punished for what their balance sheets hold – or more specifically, what the perceived risk is on their balance sheets. The price action upward seems to be signaling that the perception of the risk on the balance sheet is changing.

So, ultimately, how do we play it?

Usually, when the largest-cap players are the biggest winners in a sector over a small time window (like three to six months), I would recommend finding some mid-cap and small-cap best of breed players in that sector that have underperformed in price recently. I would likely look to pair trade it: going long the best of breed mid-cap/small-cap and short the large-cap sector ETF.

In a pair trade like that, you would be investing on the premise that the mid-cap and small-cap will catch up in performance if the market rise continues. Or, in the event that the financials sector corrects, you would likely expect the biggest recent winners to be the biggest corrections. So, you can still profit potentially even if financials go lower.

But financials here in 2012 might be the exception to the rule. Financials, because of the credit crisis and balance sheet perception issues, look like they are making up their own rules as they go along here. These beaten-down, large-cap financials have fallen so far over the last four years that there is a credible argument to be made that the trend could continue. Also, these largest large-caps will drive the sector performance more than the mid-cap and small-cap names.

So, how do you play financials? I think you continue to invest in best of breed and look for the underperformers. And consider building your hedge using the options on the sector ETF instead of the options on the stock you like in this sector.

If the market pulls back as a whole, these overperformers have the most to give back. So these largest large-cap names will drive the XLF more than ever, and the puts on that ETF should provide good coverage in the event of a sector or market pullback.

As far as best of breed names in financials, you'll have to do your own homework on those. But a few that I know have excellent management teams and haven't been stained by the balance sheet issues of the broader sector: Schwab (SCHW), TD Ameritrade (AMTD), T Rowe Price (TROW), Bank of New York Mellon (BK), and Blackrock (BLK). Start with these names and see if you can find one that meets your investing criteria!

Editor's Note: For more from Wayne Ferbert, go to Buy & Hedge ETF Strategies.
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