Ahead Of The Fed, Let's Assess The Value In Bank ETFs

Financial services, the second-largest sector weight in the S&P 500 behind technology, has been soaring and expectations of more interest rate hikes from the Federal Reserve are a big reason why. That dream could be realized this week as many bond market participants are expecting the Fed will raise rates, setting the stage for rate hikes as 2017 moves along.

The Financial Select Sector SPDR XLF, the largest financial services exchange traded fund by assets, is up more than 39 percent over the past year, leaving some to ponder whether the sector is still a credible value destination.

Valuation concerns for financial stocks could be more applicable to more focused sub-sectors, such as rate-sensitive regional banks. For example, the iShares U.S. Regional Banks ETF IAT is up 4.1 percent year-to-date, bringing its one-year gain to 48.5 percent.

“While some of the gains have come down to improvements in fundamentals, as with the broader market, much of the gains have been driven by more expensive valuations,” said BlackRock in a recent note. “The price-to-book ratio (P/B) on the sector is up over 40% from last summer’s lows. That said, valuations are still about 25% below the average since the early 1990s, although the P/B is now creeping back towards the post-crisis high.”

As its name implies, IAT holds what are described as regional banks, which significantly levers the ETF to Fed policy because regional banks are among the assets most positively correlated to rising Treasury yields.

The $790.4 million IAT holds 54 stocks, the largest members of which can be considered super regional banks, not pure regional banks. For example, US Bancorp USB, PNC Financial Services Group Inc. PNC and BB&T Corp. BBT, a combined 34 percent of IAT's lineup, all fit the bill as super regional banks.

“Valuations look less pricey relative to the broader market, which may say more about extended U.S. stocks than cheap banks. Large cap banks are trading at a 60% discount to the broader market,” according to BlackRock. “This looks very reasonable against a 25-year horizon, during which the average discount was only around 40% (see the accompanying chart). However, as with absolute valuations, relative value is less enticing when compared to the post-crisis norm. Relative valuation for large U.S. banks is now back to the highest level since early 2014.”

Disclosure: The author owns shares of XLF.