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Buy financial stocks while the Federal Reserve is pounding away on the dangers of inflation? While the yield curve is flattening (again)? While the housing market is slowing (or tanking, depending on your need for drama)?
Exactly. I think this is precisely the time that investors with the short-term, six-month time horizon of my CNBC stock picks and the 12- to 18-month time horizon of my Jubak's Picks portfolio should overweight financials.
As long as you pick the right financials, of course.
Let me explain.
About a month ago, May 12 to be exact, I predicted that the Federal Reserve was done raising short-term interest rates after it hiked rates to 5% on May 10.
I know. I know. That prediction looks "wronger" by the day. Why, just on Monday, Federal Reserve chairman Ben Bernanke told a conference of bankers that core inflation had reached a level that "if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability." The Federal Reserve, he vowed, will "ensure that the recent pattern of elevated monthly core inflation readings is not sustained."
In case the financial markets didn't get it, St. Louis Federal Reserve President William Poole, and Fed governor Susan Schmidt Bies then weighed in. Poole said, in effect, that it was better to go too far in raising rates than stop fighting inflation too soon. Bies added that it is hard to tell when the Fed should stop.
The financial markets heard that message loud and clear. The Dow Jones Industrial Average ($INDU) fell almost 200 point on Monday and then closed down another 47 points on Tuesday. The bond market was the beneficiary of this sell-off in equities. The price of 10-year Treasurys climbed -- which sent the yield falling on June 5 to 5% from 5.02% -- as investors bought safety and the Fed's promise to keep fighting inflation.
Just as you'd expect, that hasn't been great for financial stocks. Another hike in short-term interest rates would raise the cost of the capital for banks, for example, and the decline in long-term interest rates would cut what they can charge on the loans they make. Result: a squeeze on bank profits. Higher interest rates might bring a further slowdown in the real estate market. That's bad news for banks, savings and loans, and mortgage lenders. And, finally, higher interest rates bring the added risk that more borrowers, already stretched by their current payments, will default on their loans, mortgages, or credit-card debt.
Resilient banks
But the Federal Reserve's saber rattling on inflation hasn't been nearly as damaging to financial stocks as you might imagine. Sure the stocks are down in the last few days, but the drops are on the order of 1% for stocks such as Citigroup (C, news, msgs) and Wells Fargo (WFC, news, msgs).I can give you four reasons:
- The inflation fighters have hedged their "another rate hike may be needed" rhetoric with words recognizing that past Federal Reserve interest rate hikes have started to slow the economy. Consumer spending has decelerated noticeably, the housing market is cooling, job-growth was weak in last week's data, and "the anticipated moderation of economic growth seems now to be under way," Bernanke said in the same speech.
- Even if I am wrong, and the Fed does raise rates at the end of June, everybody knows that each increase brings Bernanke and company closer to a pause. We are very near the end of this process.
- This latest round of flattening in the yield curve -- at 2 p.m. Tuesday, the yield on the 10-year Treasury was just 5.008%, a scant 0.004 percentage points higher than the yield on the 5.004% yield on the 2-year Treasury note. That's the tightest spread since last March. Although the spread may narrow a bit more, the next big move from here is toward a wider spread. Even if it is just back to where the markets were before this last round of Fed-induce jitters, the trend from here is toward wider rather than tighter net interest margins.
- Before and through the stock market correction that began on May 10, financial stocks have been one of the best performing sectors. Many investors have been moving to overweight the sector -- and the sector's superior relative performance in the correction just adds to their conviction that momentum is with the sector.
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