Demystifying the Financials Sector

Stock market analysts often worry about market volatility, which is jargon for a rapid cycling of upward and downward trends in a particular stock, sector, or index. Some intrepid traders use this sort of volatility to capitalize on very quick downturns to buy and quick upturns to sell. This strategy is considered very dangerous and full of risk by most long-term investors. They view it as something akin to playing roulette.

Many day trading strategies exist to help these brave traders make these volatility based plays. The long-term investors hate volatility because it makes the market less certain and picking stocks more difficult. As you may have predicted, the financial services sector is prone to high levels of volatility. The reason that everyone doesn’t avoid high volatility stocks and stock sectors? Great risk often equates with great reward in the stock game.

If a company is in the business of handling other people’s money, then it likely fits into the financial industry. Banks, insurance companies, real estate companies, and financial service companies are the major supersectors in this industry. To get an understanding of exactly what makes stocks rise and fall in this industry, you must have a grip on each of the subsectors.

As a general rule, financials perform best in a low-interest rate environment, but that statement must be qualified. The value of long-term debt such as mortgages is higher when interest rates are lower. In periods of low-interest rate mortgages (and other long-term debt), the general rule will not hold. The complex interaction of current interest rates and long-term interest rates are part of what makes this sector so potentially volatile.

When the business cycle is on the upswing, and there is a high level of confidence in the economy, both individuals and businesses seek to expand wealth. This is often accomplished through growth, which means that these individuals and corporations need financing. Businesses build and replace infrastructure, and individuals increase personal savings and investing.

These are heady days to be invested in the financial sector! Financials make up a large portion of the S&P 500, consisting of household names like Bank of America, Citigroup, and JP Morgan Chase. If you were invested in these financials at the beginning of the Trump Rally, you fared very well! (See a chart for November through December of 2016 for Goldman Sachs Group Inc. (GS) if you are a visual learner). Investors can’t afford to become complacent given these meteoric rises in equity. Never forget the devastating losses to this sector when the real estate bubble burst in 2008.
Several investors use the Financial Select Sector SPDR ETF (XLF) to track the overall health of this sector.

The volatility of that index has been quite low over the past three years (Beta = 0.93), debunking the notion that financials is a volatile sector that should be avoided by prudent investors. History teaches us that the sector’s volatility can, however, increase dramatically during uncertain economic times. In this sector, the prudent investor will shy away from a “buy and hold” strategy. The correct strategy is to follow the advice of Mr. Cramer: “Buy and Homework.” That homework must include drilling deep into the underlying business and inspecting the balance sheets before you pull the trigger. It also means tracking the larger economy, with a special emphasis on what the Fed is doing with interest rates.

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