The Financials sector has displayed some interesting characteristics over the last nine months or so. In the weeks following the election of Donald Trump, Financials had the best run of any sector in the S&P 500. From November 8, 2016, to the end of the year, the sector surged +16.8%, with Telecom coming in at a distant second (+12.8%). Most sectors were up only single digits over that time period.

To note was that the Energy sector was the third best performing sector over that post-election period, having risen +9.0%. The surge of Energy and Financials, in my view, had a distinct cause: the expectation of looser regulations and major tax reform from the new administration. What happened ultimately is that investors may have overshot their expectations, evidenced by the fact that Energy and Financials were among the worst performing sectors from January 1, 2017, through the end of the second quarter.

The rocky early days of the new administration and the health care fiasco are among the main culprits for the rotation, in my opinion. Investors took note that sweeping deregulations and tax cuts may take much longer than previously anticipated, even though Republicans controlled both chambers of Congress and the White House. The Energy sector declined -12.6% and Financials ticked up 6.9% in the first half of the new year, which put them at the bottom of the pack performance-wise.

The Tide May Be Turning for Financials

Investors have tapered their expectations for quick, major reforms in the banking sector, and that could be a good thing. A macro model of bank stock performance and interest rates suggests that the market is not pricing-in much optimism regarding deregulation. One analysis suggested that the initial “Trump trade” rally in Financials came with expectations for a major regulatory overhaul with a 12% premium. But since then, that premium has dropped to a mere 2%.

For investors, that could mean plenty of upside surprise available if regulatory changes end up happening, which we think is probable. There is no set timetable for when or if these regulatory changes will pass, but we tend to believe there is more consensus in the Republican party on issues like regulation and taxes versus an issue like health care, where no one can seem to agree on policy.

With optimism for regulatory changes falling, even the slightest change could have an outsized positive impact on Financials. As it stands now, the banking system is overseen by a patchwork of regulators, many of which have conflicting interests and overlapping jurisdictions. In a phrase, it’s kind of a mess. The passing and implementation of Dodd-Frank regulations had good intentions, and some of the rules are worthwhile. But, the sheer complexity and confusion created in the rollout (which is still occurring all these years later), gave banks a lot of uncertainty about what the playing field would look like going forward. Banks are relieved that the government appears poised to clean the regulatory environment up. If anything, the most impactful accomplishment of doing so would not necessarily be actual rule changes – it would be eliminating uncertainty.

A potential upcoming surge in dividends and share buybacks could also bolster the case for Financials. Following the latest stress tests (which all major banks passed), the Federal Reserve approved an aggregate 36% increase in dividends and an average $9.8 billion of share buybacks per bank. Should banks undertake both actions, it could bolster shareholder equity and improve the overall view of the sector.

The Bottom Line for Investors: What’s Your Exposure to Financials?

In my view, banks are in a strong position to do well going forward, assuming we see solid earnings growth and modest but positive GDP growth in the U.S. economy this year – both of which we expect. The question for investors is: how well diversified/exposed are you to the Financials sector, and what can you do to check your portfolio and make any needed adjustments?

At Zacks Investment Management, our Dividend Strategy has financial exposure in-line with the Russell 1000 Value index, and we expect that any bump in dividend yields from banking stocks could boost the overall yield of our strategy, too. Learn more about how this strategy can fit into your overall investment goals, and perhaps add some elements (like Financials exposure) that you may not already have by calling us at 1-888-600-2783.

In addition, I invite you to download our latest Investing Update and Asset Allocation report absolutely free. This exclusive 23-page briefing can help you evaluate the current direction and allocation of your investment portfolio. It's filled with facts and predictions regarding where the S&P 500 will be at year's end, current odds for a recession, GDP growth, employment, long-term interest rates, and much more.


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