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John Manley

Four more years for the financials?

AdvantageVoice® Blog—11-19-12
John Manley, CFA, Chief Equity Strategist

Investors and strategists constantly have to review their progress or lack of it. Having taken positions, investors must monitor and evaluate those positions. Nothing goes up or down forever; price changes must be noted and new events taken into consideration.

Admittedly, this is a lot easier to do if you have been right. Deciding whether to take a profit or let it “ride” may not always be easy, but it is a pleasant thing to contemplate. It is harder when the market has gone against you. For me, that is the case with the financials sector.

Although it wavered in the first part of 2012, the financials sector has been a stellar performer over the last six months. This has been somewhat surprising to me. While groups such as the insurers seemed to have solid fundamentals, the largest segment of the sector—the banks and brokers—appeared to have mediocre valuations and uninspiring (if not questionable) fundamentals. The quality of earnings and assets was uncertain, and it seemed as if the regulatory environment was going from bad to worse.

Also, the historical analogies argued against an extended period of outperformance. Like the energy sector in the late 1970s and the technology sector in the 1990s, the financials sector had been the overwhelming leader in a strongly rising market. Energy took 12 years to recover its leadership and technology took almost 10 years. Why should financials come back after only five years?

Part of the answer over the last six months has been simple: very strongly positive monetary pressure. The sector was the prime beneficiary of QE3. As the Federal Reserve pushed money at the economy, some of that liquidity flowed into financial corporations and pushed the value of their shares higher. The sector was also helped by the increasing stability of the housing market. As home prices stabilized and the housing market began to clear, the status of the banks’ asset exposure went from “open ended” to finite and manageable.

I expect that both of these positive forces will remain in place in the months ahead, although I doubt that either will accelerate. The Fed should continue to stimulate but, in the absence of significant economic weakness, I doubt that it will meaningfully increase its efforts. Housing should remain stable, but any real improvement seems unlikely to me until manufacturing and employment improve and the pain of the last five years recedes into distant memory.

I believe that the biggest fundamental change for the financials sector in the next six months will be in the regulatory environment. In the months before the election, the markets pondered the possibility of a Romney victory and a shift of power in the Senate. This seemed to dull the edge of existing regulatory legislation and slow its implementation. With the election behind us, this possibility no longer exists. While legislative gridlock might possibly occur, it seems unlikely that regulatory gridlock will. In such a situation, the regulatory environment for the financials sector should become more challenging and the potential for profit improvement less likely.

In summary, I believe that the tailwinds that have helped the sector in the recent past will not increase while the headwinds that may hamper it will. While the situation for the financials may not be as dire as it seemed six months ago, I believe that the “new news” for the area will have a much less positive tone and that the likelihood of underperformance is still real.

The views expressed are as of 11-19-12 and are those of Chief Equity Strategist John Manley, CFA, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.

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