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5 reasons to watch financial stocks in '03
To predict the direction of the overall market in 2003, keep an eye on the financial sector. Here's why it's positioned as a great barometer.
By Jim Jubak
Last year around this time -- Dec. 22, 2001, to be precise -- I wrote that anybody who wanted to predict the direction of the stock market should watch the airline sector. If airlines were in rally mode by February, it was likely that the bear market was behind us. If the sector's stocks went into retreat, it meant tough times for the entire stock market in 2002.
It turned out that airline stocks were a great indicator -- and a lousy investment. The sector gave back the gains it had made after hitting lows in the aftermath of the Sept. 11, 2001 terrorist attacks and then kept on giving. For example, Continental Airlines (CAL, news, msgs) rallied from its Sept. 21 low of $14.66 to hit $34.80 on March 4 before beginning a retreat that took the shares down to a low of $3.65 on Oct. 9, 2002. Since then, the stock has rallied along with the rest of the market.
This year -- instead of airlines -- investors looking for an indicator of market direction should be watching the financials.
Why this sector this year?
First, this is historically the strongest season for financial stocks. If financials can't climb now, it's unlikely that they'll be able to do so later in the year. From January through May, bank stocks go on a roll -- the average return for the S&P Banks Index ($BIX.X) during the period, according to the Stock Trader's Almanac, has been 9.7%. Securities brokers and dealers knock the cover off the ball from December through April with the Securities Broker Dealer index ($XBD.X) up 24% on average during that period.
Second, the sector is near one of those traditional stock market sweet spots. In recent fourth-quarter earnings reports, both Goldman Sachs Group (GS, news, msgs) and Lehman Brothers (LEH, news, msgs) talked about how tough business would be for the first six months of 2003, but said they expected a pick up in the second half. For Goldman Sachs, for example, Wall Street is now expecting just 5% earnings growth in the first quarter of 2003 and just 7% in the second quarter before business picks up to produce a 15% increase in earnings per share for the full year.
Since Wall Street typically anticipates improving earnings stories by about six months, these stocks should climb in the first part of 2003, if investors find any credibility to these projections at all. If the stocks don't climb, it's a strong indicator that investors remain deeply skeptical of projections for improved economic growth in the second half of 2003. That would be bad for stocks in almost all market sectors.
Investors and war worries
Third, the sector is good at filtering out some of the short-term worries now bedeviling the stock market and very sensitive to more important long-term trends. The day-to-day fluctuations in the price of a barrel of oil, for example, as investors vacillate between "Yes, we're going to war with Iraq soon," to "No, we're not going to war with Iraq soon," has much less impact on this sector (banks don't run on oil although they may run on oil dollars) than it does on energy-intensive sectors such as the airlines.
Similarly, public attitudes toward travel, which also seem to fluctuate daily with the latest war rumors, produce immense volatility in travel and hospitality stocks but not among brokerage equities. On the other hand, the financial sector is extremely sensitive to important long-term trends, such as the direction of interest rates and the potential for inflation. It will be hard for the stock market as a whole to do well if rates start to advance at more than a creep and if inflation isn't as dead as everyone now fears it is. The financial sector, however, is likely to react even before the general market in these areas.
Fourth, everyone on Wall Street now watching the stock market's behavior is looking for a group that has the fundamental prospects and market capitalization to lead the market upward. The consensus is that the technology sector, one traditional candidate, isn't up to the job this time because of anemic growth projections for 2003 and still-hefty valuations. The financials get the nod from many Wall Street professionals as the sector with the most potential for leadership. If financials go up, many on Wall Street will see that as a sign that the market now has the leadership to advance further. If financials falter, a lot of money will remain on the sidelines.
No more black cloud
And fifth, the announcement of a settlement between Wall Street investment houses and regulators led by New York Attorney General Eliot Spitzer has removed a black cloud of uncertainty over the financial sector. Now analysts know to a reasonable certainly how big a one-time hit the big Wall Street players will take. And frankly, as big as $1 billion in fines sounds, it will hardly have a major impact at any of these companies. Citigroup (C, news, msgs), which is likely to pay the biggest fine at $325 million, had net income of $14 billion in 2001. Morgan Stanley (MWD, news, msgs), which faces a $50 million fine, had net income of $3.6 billion in 2001. The size of the one-time charges these companies will take won't shock Wall Street. And that means the sector is relatively free to respond to fundamentals such as economic growth, interest rates, and inflation that will be the key factors in determining how the stock market as a whole will behave in 2003.
If you want to follow the performance of the financial sector as a market indicator, I'd suggest tracking the two indexes I mention above -- the Standard & Poor's Banks index and the Securities Broker Dealer index . If you want to track just one stock as an indicator, I'd suggest either Goldman Sachs, if you want to concentrate on the investment banking and institutional side of the financial services business, or Citigroup, if you'd like more exposure to retail investing in your indicator. In my opinion, individual investors are likely to return as customers to the financial services business after corporate and institutional customers. So, that might make Citigroup a lagging indicator, but tracking that kind of indicator too has its value.
If instead of tracking the sector, you'd like to invest in it to take advantage of the very strong seasonality, you can try iShare, the exchange-traded sector baskets of stocks created by Barclays Global Investors; "HOLDRS," Merrill Lynch's similar product; or an index mutual fund. None are ideal in my opinion. They're either too broad, like the iShares S&P Global Financial Sector Index (IXG, news, msgs), or too narrow like the Regional Bank HOLDRS (RKH, news, msgs).
The best bet may be the iShares for the Dow Jones U.S. Financial Sector Index Fund (IYF, news, msgs). For more on these trading vehicles, see the links at left.
If you're looking for a single Wall Street stock play, Goldman Sachs is worth a look. But see my column, "Hidden risks that could hurt your stocks," on Goldman's move to take on new risk by expanding its proprietary trading.
And if you're looking for a lower risk financial pick look at some of the smaller banks in my Oct. 22 column, "How to tell a smart bank from a dumb one."
New developments on past columns
Economy paints the Fed into a corner
The almost-final numbers are in -- until the annual revision next summer, anyway -- on the economy in the third quarter of 2002. And the good/bad news is that growth was strong but not as strong as it looks. Gross domestic product grew at a robust 4% annual rate during the period, the same rate as in the Commerce Department's previous estimate for the quarter. (For more on how these numbers get revised and revised again see my Aug. 8 column, "Economy paints the Fed into a corner.") But business investment, that single-most important indicator of the future health of this economy, showed a 0.8% decline -- worse than the earlier estimate of 0.7% and the eighth straight quarterly drop. Business inventories climbed $18.8 billion in the quarter, up from the earlier $15.5 billion estimate. Because businesses build inventories in hopes of future sales, that gain may explain why GDP growth was so strong in the third quarter and why so many economists -- and the Federal Reserve -- believe growth will be weaker in the fourth quarter when companies sell this inventory but don't reorder. After-tax corporate profits, which some analysts on Wall Street believe is a better indicator of true profitability than reported corporate earnings right now rose 2.1% during the third quarter after a 1.7% gain in the second quarter.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Continental Airlines. He does not own short positions in any stock mentioned in this column.
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