Schwab Sector Views: Financials: Danger or Opportunity?

Schwab Sector Views is our three- to six-month outlook for 10 stock sectors, which represent broad sectors of the economy. It is designed for investors looking for tactical ideas. We typically update our views every two weeks.

The financials sector is the second-largest in the S&P 500® Index and a key part of the American economy. It has also been under attack by politicians and unloved by investors since the financial crisis, resulting in some very volatile performance. We have been both criticized and praised for our outperform view, depending on when investors were looking. So, following the dismal May jobs report and a sharp decline in Federal Reserve rate-hike expectations, the question is: Does the financials sector represent source of danger or opportunity for investors?

Both.

As always, investments have both risks and potential benefits, but while the danger signs are blinking slightly brighter for the financials sector, we continue to see more potential opportunities and are sticking with our outperform rating—for now.

The financials sector tumbled around the start of the year because of recession concerns. It then rebounded nicely and outperformed from mid-February through May as those concerns faded and expectations of a rate hike rose. Then came the disappointing May jobs report.

The Department of Labor said the U.S. economy added just 38,000 jobs that month, leading the market to slash its expectations for a Fed hike. That hit the financials sector in turn. However, we believe the retreat is overdone at this point. As we’ve said before, investors should avoid putting too much importance on any single piece of economic data, especially one that is typically a lagging indicator like the jobs report.

Broadening the scope to include other sources of data reveals a slightly different story, one of a tightening job market, increasing wages, strengthening housing and solid retail sales. To us, this doesn’t look like an imminent recession, and the possibility of a Fed hike in the near future remains on the table. That bodes well for the financials sector.

And the jobs number didn’t tell the whole story. Jobless claims, a leading indicator, continue to run near historically low levels and show no signs of a softening job market. Meanwhile, the recent JOLTS (Job Openings and Labor Turnover Survey) showed the number of job openings matched the record high seen in July of last year, and the number of unemployed per job opening dropped to its lowest level since May 2001. And briefly, there’s been much talk of the U-6 unemployment number being a more accurate measure of the labor force because it includes such things as part-time workers who would like to be working full time and marginally attached workers—meaning those who aren’t actively looking, but could be enticed to take a job. The number of U-6 unemployed per job opening is at its lowest since March 2007.

The forward-looking job report indicates strength

Source: FactSet, U.S. Dept. of Labor. As of June 22, 2016.

As does the JOLTS report

Source: FactSet, U.S. Bureau of Labor Statistics. As of June 22, 2016.

The strong jobs market, combined with another solid retail sales number for May, leads us to believe the U.S. economy is improving and will allow the Fed, which has indicated its desire to get to a more “normal” level of interest rates, to hike rates sooner than the market expects.  

Additionally, the housing market has improved and mortgage demand has been strong, which should help banks to increase their revenue.

A solid housing market should help financials

Source: FactSet, Mortgage Bankers Association. As of June 22, 2016.

Also, banks appear to have plenty of dry powder should demand for loans start to increase. The Federal Reserve and Ned Davis Research found excess reserves stood at a whopping $2.3 trillion as of June 3, up from about $900 billion in 2010 and virtually zero before the financial crisis. And while having a cushion of excess capital can be desirable at times, it can also restrict potential economy-enhancing investments.

It also hints at the heavy regulatory burden placed on the financials sector over the past several years. But there are some glimmers of hope here as well. Despite the heated political rhetoric being leveled against the financials sector, there does seem to be an increasing realization that the regulations may have gone too far and had unintended consequences. While there is virtually no chance of regulations being rolled back in this election year, it seems the flow of new rules may at least slow. And though it will go nowhere this year, the financials sector got a boost when the Chairman of the House Financial Services Committee announced a proposal to overturn much of the massive and onerous Dodd-Frank law.

There are certainly dangers to the financials sector that shouldn’t be ignored. Negative interest rates in much of the world are pushing money into the U.S. Treasury market and appear to be flattening the yield curve, which could pressure margins in the financials sector and make it more difficult for the Fed to raise interest rates. Additionally, depending on how the upcoming U.S. election turns out, the regulatory environment could get worse next year for the financials sector. But for now, in an environment where it’s difficult to find investments that seem like a good value, we think the potential opportunities outweigh the dangers. We also acknowledge that the May jobs report, reduction in rate-hike expectations and flatter yield curve have raised the level of concern and threaten our outperform rating.

Schwab Sector Views: Our current outlook

Sector

Schwab Sector View

Date of last change to Schwab Sector View

Share of the
S&P 500 Index

Year-to-date return as of 06/21/2016

Consumer discretionary

Marketperform

07/17/2014

13%

1.20%

Consumer staples

Marketperform

05/07/2015

10%

7.83%

Energy

Marketperform

11/20/2014

7%

15.66%

Financials

Outperform

05/07/2015

16%

-2.99%

Health care

Marketperform

12/13/2012

15%

-1.68%

Industrials

Marketperform

01/29/2015

10%

6.64%

Information technology

Outperform

04/29/2010

20%

0.61%

Materials

Marketperform

01/31/2013

3%

9.76%

Telecom

Underperform

09/12/2013

3%

20.05%

Utilities

Underperform

05/23/2013

3%

18.44%

S&P 500®  Index (Large Cap)

 

 

 

3.31%

Source: Schwab Center for Financial Research and Standard and Poor's as of 05/31/2016.

Clients can use the Portfolio Checkup tool to help ascertain and manage sector allocations.

What is Schwab Sector Views?

Schwab Sector Views is our three- to six-month outlook for 10 stock market sectors, which are based on the 10 broad sectors of the economy.

The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:

  • Outperform: Likely to perform better than the rest of the market.
  • Underperform: Likely to perform worse than the rest of the market.
  • Marketperform: Likely to track the broad market.

How should I use Schwab Sector Views?

Investors should generally be well-diversified across all stock market sectors. You can use the Standard & Poor's 500 allocations to each sector, listed in the chart above, as a guideline.

Investors who want to make tactical shifts in their portfolio can use Schwab Sector Views' outperform, underperform and marketperform ratings as a resource. These ratings can be helpful in evaluating and monitoring the domestic equity portion of your portfolio.

Schwab Sector Views can also be useful in identifying stocks by sector for potential purchase or sale. When it's time to make adjustments, Schwab clients can use the Stock Screener or Mutual Fund Screener to help identify buy or sell candidates in particular sectors. Schwab Equity Ratings also can provide an objective and powerful approach for helping you select and monitor stocks.

Next Steps

Talk to Us
To discuss how this article might affect your investment decisions:
-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

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