CHICAGO U.S. financial services stocks may be the most unloved sector in recent memory, but they may end up prospering in the coming year.
Individual investors have had solid reasons to be sour on financials since 2008. Earlier this year, JPMorgan Chase & Co disclosed a $6.2 billion loss in trading as part of its "London Whale" scandal. Bank of America Corp and Citigroup Inc continue to struggle, and all of the megabanks were involved in a legal settlement over the troubling "robo-signing" of mortgage documents.
The balance sheets of the megabanks are still bruised and hiding untold woes of bad debts; their share prices have largely reflected uncertainty since 2008.
"Megabanks don't deliver good shareholder value," said Sheila Bair, former Federal Deposit Insurance Corp chairwoman and head of a nonprofit bank watchdog group called the Systemic Risk Council.
"They have a `complexity discount,' are too hard to manage and their finances too opaque to the investment community," Bair said in a speech at the Executive Club of Chicago on Wednesday.
Only 23 percent of Americans say they trust the country's financial system, while banks got a slightly higher 33 percent approval rating, according to the quarterly Chicago Booth/Kellogg School Financial Trust Index released on October 30.
The U.S. stock market, though, has not reflected the public's dim view as the financial sector, which has been the top-performing industry in 2012. Through Wednesday, the sector, as measured by Standard & Poor's, was up about 20 percent this year, nearly double the gain of the broader S&P 500 Stock Index.
Keep in mind that the financial services sector encompasses not just the largest banks but also smaller ones and credit card issuers. More significantly, it includes insurers and real-estate companies, which have both been participating in the economy's rebound and have much stronger balance sheets than the megabanks.
If you are looking for growth in your portfolio, start with the regional banks, which typically have been conservative in their lending standards and operations and have been bolstering their balance sheets
Should you would like a capitalization-weighted approach, then consider the iShares Dow Jones U.S. Regional Banks ETF. One-third of the fund's portfolio is in two stocks: U.S. Bancorp and PNC Financial Services Group Inc.
The SPDR S&P Regional Banking ETF tracks an index of 76 mid-sized banks. It holds major players such as PNC Financial, BB&T Corp and SunTrust Banks Inc.
No one bank dominates the portfolio, which employs an equal-weighting strategy. Each stock comprises about 2 percent of the fund, reducing concentration risk significantly. The ETF was up about 16 percent for the year through October 30.
Of the two funds, I prefer the SPDR, which also gives you more of a sampling of the less-popular regionals.
For a broader mix of financials, the PowerShares Dynamic Financials ETF offers more possibilities. It is a mix of megabanks, regionals like KeyCorp and major insurers like Allstate Corp. It also holds Class B shares of billionaire investor Warren Buffett's holding company, Berkshire Hathaway Inc.
Another alternative is the Vanguard Financials ETF, which, in addition to the megabanks and regionals, offers a more than 20 percent holding in real estate companies such as Simon Property Group Inc.
My modest prediction that financial stocks will appreciate even more is based on Congress resolving its debt ceiling/fiscal cliff issues and no other financial calamities developing. I also assume that the U.S. recovery will continue in tandem with the Federal Reserve's continued easing policy and that financials from regional banks to insurers will reap the benefits.
For no matter how Congress fumbles and fumes, the Fed said it would maintain its low interest rates and keep buying government and mortgage securities into 2014, when Chairman Ben Bernanke's term ends. If the economy remains sluggish, quantitative easing is likely to continue to bolster banks in the near term. A low-interest-rate environment allows banks to borrow at low rates and lend out at a profit.
A continued resurgence in housing and employment will also help. Even increased regulation will strengthen banks.
The greatest caution with financials now is that they will appreciate only as long as they are darlings of institutional investors, inflation is relatively tame and the economic rebound is on track.
Big banks, though, still face myriad unresolved issues. The industry has been vigorously fighting regulation of its profitable trading desks, which involve still mostly unregulated derivatives.
How much systemic risk is still embedded in the system because of bank-traded derivatives, also dubbed "financial weapons of mass destruction" by Warren Buffett? No one quite knows.
Only 30 percent of the Dodd-Frank financial reforms have been implemented, and how the whole suite will affect banks' earnings remains unknown. Many observers say that is a negative factor long-term.
Yet if you can largely avoid loading up on the largest banks and stick with the regionals and insurers, you should be able to weather the next storm somewhat better than with an all-megabank strategy, which still has to be the ultimate contrarian bet.
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(The author is a Reuters columnist and the opinions expressed are his own.)
(Editing by Beth Pinsker Gladstone and Lisa Von Ahn)