Why the Financials? A Multitude of Reasons (FAS)

Let’s kick off this week with a word about earnings multiples.

We’ve said it before, and we’ll say it again – multiples are Wall Street’s great fungible. They’re the gravy that gives the potatoes flavor, the gown that gives the old, torn-down hussy her lure.

When Wall Street wants to keep a bull market alive, she stretches multiples – Price to Earnings, Price to Book, Price to Sales – whatever you got, Wall Street pulls and pries it to the full extent to justify the purchase of stocks.

Because Wall Street is a moneymaking enterprise like no other.

wench

It works like this:

Brokerage X has a large and growing clientele that’s buying stocks.

Brokerage X is therefore making lots of commissions.

But Brokerage X’s analysts see that many stocks, like, say, Microsoft and Caterpillar, are trading with P/Es of 16 and are reporting earnings no better than they did a year ago.

Brokerage X worries that if clients get anxious about Microsoft and Caterpillar – and maybe the rest of the market – because earnings aren’t growing, they’ll stop buying stocks altogether.

Brokerage X doesn’t want commissions to dry up.

Or bonuses.

So they say, “Don’t worry, friends – Microsoft and Caterpillar may not be growing earnings, but that won’t stop us from expanding multiples, from setting higher price targets and informing our clients that MSFT and CAT are really worthy of P/E ratios of 19 or 20.”

After all, clients have cash.

And they want to buy.

So why disappoint them?

And the bull market is kept alive!

Please look at the chart below. It’s a visual of all the major market sectors and their changing earnings multiples from the beginning of the calendar year through the present.

peratio

As you can see, the S&P 500 began the year with a P/E of 17.06 and has seen that multiple stretched by nearly a full point to its current 17.93. That’s a 5.1% expansion. If you consider that the actual price of the index is up by 5.88%, then it follows that real earnings growth accounted for just 0.78% of the market’s rise, while the rest (5.1%) was due entirely to the ethereal abstractions and willful longings of market participants.

That is, investors were willing to drive up prices 0.78% in accordance with verifiable corporate earnings growth, and then another six and a half times that amount (!) because… well, because they felt like it. Or someone told them it was OK. Or because that’s what their friends were doing.

What the…?

Multiples will continue to grow, friends, and there is nothing we can do to stop them, nor need we. So long as Wall Street believes the sun is shining, they’ll do everything in their power to make hay.

Your job is to remain on the right side of the trade.

Long.

What about that box around the Financials…

Nothing escapes your keen eye, you Market Wizard, you!

lizzard[I said ‘wizard’.]

We boxed the financials because she’s the sector that possesses the smallest P/E and among the worst year-to-date price rises.

And while that may be bad news for some, we view it differently.

In the eyes of Wall Street, the Financial sector now possesses all the right characteristics for a full scale sector rotation segue.

Perhaps they’ll pull cash from the Materials or Health Care sectors, where both earnings multiples and prices have gotten bloated of late, but that’s a secondary issue. What counts is that the Financials represent the sector whose P/E ratio is now the most convenient to expand.

And so it will be expanded.

Here’s a chart of the Russell 1000 Financial Services Index for the last 34 months (since the last major bottom) –

russell

We have a very stable price channel in place for nearly three years and little sign of toppiness from any aspect of the chart.

And that’s a go, as far as we’re concerned.

But for your evidentiary pleasure, we also reproduce a chart of the Credit Suisse Fear Barometer, a mostly unreliable tool that we believe is better employed as a contrary indicator of where the market is next headed.

Have a look –

suisse

The CSFB is a theoretical gauge of how expensive PUT protection is for a portfolio, and as you can see, it’s now darned expensive.

That essentially means that a lot of folks are worried about a potential market top and are buying insurance (PUTs) to hedge against that eventuality.

But we aren’t.

We aren’t buying any of it.

More fear?

Bring it on.

And consider a long CALL position on the Direxion Daily Financial Bull 3x Shares (NYSE:FAS) to capitalize.

Go out to the end of the year at least.
Because the Financials are due to play catch-up.
Many happy returns,

Matt McAbby, Senior Analyst, Normandy Research

Share your thoughts...

We encourage people to join in on the discussion. Please keep in mind however, that all comments are moderated according to our comment policy, and all links are nofollow. Let's keep the conversation professional and meaningful.