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Conventional wisdom in the market suggests that the financial sector stands to benefit from the Fed tightening cycle. Complicating this theory is the dramatic outperformance already seen of some financial stocks since early 2016. Which stock above is more likely to continue the outperformance?
Is this investment theme already priced in?
I would exercise caution and reference the investment adage “buy the rumour, sell the fact”. The chart below shows how an expected rising interest rate theme (e.g. rising USD) can play out early.
Like the USD, the strong performance of these two financial stocks took place leading up to the third rate hike. The best time to buy financials will likely prove to be well before the first hike. I have not convinced these two stocks necessarily have a strong year just because of further Fed tightening.
The Goldman Sachs Group, Inc. (NYSE: GS)
On a forward P/E of around 11 times, Goldman’s has its temptations when considering the overall elevated prices of the US market. I don’t think this measure alone though is a good method to use in trading this stock. Like I have witnessed with resources stocks, I find a tendency for analysts to extrapolate with their forecasts.
The “E” part of the equation was artificially high prior to the last bear market. This meant that buying on a low P/E then didn’t prove wise. In more recent times the P/E spent a couple of years leading up to mid-2015 quite low at about 10.
From this point, the stock had a major correction over the next 12 months. The powerful rally then began after the company’s prior 12-month earnings were declining. The stock rose strongly from a much higher P/E ratio in the first half of 2016.
The EPS numbers from Goldman Sachs over the longer term are more volatile than JP Morgan. This is primarily due to their business mix, as is displayed below.
Challenging Period for FICC Segment
They have a heavier dependency on revenues from the institutional segment. The fixed income currencies and commodities (FICC) segment has been challenging for some time now. Low volatility in outright interest rates, currencies, and tight credit spreads have been a major feature of markets.
All act as headwinds for this division. Such has been the extent of this theme, I can envisage this changing for the better soon. The problem will be though if increased volatility is a sign that the global bull market is ending. This is not the extent of the volatile scenario that Goldman Sachs would wish for.
Buyback Plan, Impressive Growth
The issues in the FICC segment has been more than made up for in other areas. The growth last year outside of Institutional Client Services related businesses has been impressive. The outlook here though is quite dependant on your view of whether the global equities bull market can continue.
Management has done a good job in capital management in recent years with significant share buy backs. As regulation in the industry has demanded, their capital ratios have still managed to strengthen considerably. This means the Goldman Sachs of today is likely to be viewed as a lower return but lower risk stock compared to over a decade ago.
They see future key opportunities in the lending space.
In the longer term this will make up a greater percentage of their earnings. They are well positioned in terms of their balance sheet, technology, scale and risk management skills to grow this area.
JPMorgan Chase & Co. (NYSE: JPM)
JP Morgan has far less dependency on revenues from the Institutional Client Services related businesses. Like Goldman Sachs, earnings expectations seem relatively modest in terms of the forward P/E for JP Morgan. The price to book ratio, on the other hand, is somewhat elevated, after a strong run in the shares from 2016.
I am not that surprised investors have been willing to pay up a little. JP Morgan are less reliant on the health of financial markets than Goldman Sachs for their revenues. Any further signs we are in the latter stages of the equities bull market would likely see a preference for JP Morgan.
EPS is Growing
It is worth keeping in mind how they stood out among their peers for their superior management in navigating through the last bear market. At first glance, the below chart may seem a little volatile, but in fact was very steady compared to their competitors.
Any premium attached to the share price for superior management could be challenged if CEO Jamie Dimon were to depart. As time goes on I suspect the market will become more comfortable of the succession plans in place. It is certainly a possibility that has been well flagged for numerous years now. Recently the company addressed the issue.
Boost Interest Margin, Tax Reforms Benefits
Currently they are experiencing good earnings growth thanks to numerous tailwinds. They continue to be well positioned this year with their sizeable exposure to consumer banking. Economic growth should remain solid this year and expected interest rate rises would boost their net interest margin. We are at the stage of the rate hiking cycle where for the time being lending is still likely to remain strong. The company has stated they expect to benefit from the latest tax reforms.
Outside of these macro tailwinds, credit must go to management for their recent strong performance. They are recording strong deposit growth and lending growth when compared to competitors, and they continue to regularly beat earnings estimates. At the same time loan loss provisioning and overall costs remain in check.
Ironically one of the short-term risks for JP Morgan are that they have set the bar high for when they next report. The positives I wrote about have been reflected in some good outperformance of other financial stocks.
I would still nonetheless prefer them to Goldman Sachs as I see more certainty over the growth drivers within consumer banking. Interest rate rises can benefit both stocks so long as Fed policy is not perceived as significantly putting the brakes on growth. I have less certainty over the ongoing prospects of continued robust capital markets, of which Goldman Sachs is more dependent on.