Broad market averages finished 2014 at or near their all-time highs, confounding a number of market experts who have spent considerable time and effort discussing the likelihood of a market correction, only to witness the appetite for stocks, and the resulting momentum, continue. As we look ahead to 2015, those same familiar voices of pessimism are out there. However, at this point, even the most optimistic market participants have found it wise to step back, question their convictions, and assess whether this rally can continue.  

More than any single factor, the market’s rise has been fueled by Federal Reserve policy that has consistently pushed aside the fear of higher interest rates. In her most recent statement in December, Janet Yellen asserted that investors should be “patient” about the timing of an interest-rate hike, and indicated that the Fed was prepared to keep rates low. …

…Given the likelihood that low rates cannot and will not continue forever, prudent investors will recognize this fact and reallocate to those sectors that would benefit the most from this prospective environment. One such sector is financial services.

Certainly, the financial-services sector has had a great deal to offer as a value play. Share prices of many of the large money-center banks have still not fully recovered from the declines precipitated by the 2008 financial crisis, and even many of the healthier players have lagged the S&P 500 in the six-year period from the end of 2008 to 2014. Price-to-earnings and price-to-book value ratios are consistently cheaper for financials as compared to the overall market.

Because the financials are consistently cheaper, some are concerned that the sector is a classic “value trap.” Why are the financials cheaper? It might have something to do with the industry’s changes since 2008, such as higher government regulation that has hampered firms’ capacity to diversify revenue streams and grow earnings. Low rates and a flattening yield curve mean that net-interest margin, the spread between a bank’s cost of capital, and what it earns from loan activity, is not as predictable as it was a decade ago. …
…Higher interest rates, when they are announced by the Fed, will likely precipitate a knee-jerk negative reaction from the market. Then when the dust settles, the fact that banks tend to thrive in a growing economy, coupled with the fact that higher interest rates means higher net interest margin, will collectively serve as a catalyst for investors in the sector. This especially as higher net interest margin largely goes right to the bottom line for banks since it’s a business with higher fixed costs and lower variable costs.

How should you best position your portfolio to take advantage of these potential trends? It’s often times perilous in this sector to bet on a single stock or company and expect it to capture the trend, particularly given the company-specific issues (e.g., bad trading losses) that harmed so many investors in Lehman Bros. (among others) during the 2008 crisis period. Fortunately, there are a number of sector ETFs that offer a basket of stocks and the ability to take more of a direct focus, say on the regional banks, or on the small- and mid-cap end of the spectrum. … 


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