Financial Sector to Continue Strong Performance in '06, Research Company Says

Despite recent run-ups in the performance of financial stocks, the financial sector is poised for even greater growth in 2006, according to Michael Krause, President of AltaVista Independent Research. Krause expects financials to be one of the top-performing sectors this year.

“Up until now, the share price for the sector has simply tracked expected profits,” says Krause, “and we think these could go much higher. With corporate profit margins at all-time highs, companies will have to seek out mergers and acquisitions to keep growing. And they have the cash to do it. The trend, already begun, will generate hefty fees for Wall Street.”

To illustrate his point, Krause points to the performance of the Financial Sector SPDR (XLF), one of the nine exchange-traded index funds that together compose the S&P 500. XLF rose 2.8% in the first quarter of 2006, in the process hitting an all-time high.

According to AltaVista, companies in the Financial Sector SPDR (XLF) are expected to post 17% earnings growth in 2006, greater than for any other sector. From a valuation perspective, its shares are cheaper than the S&P 500 on every metric AltaVista monitors.

In additional support of his view, Krause also cites the rotation into financial stocks that typically accompanies the end of a Fed tightening cycle, which he anticipates will occur after one or two more rate hikes.

Other sectors Krause likes include industrials and technology. Both outperformed the broader market in the first quarter of 2006, with the Industrial Sector SPDR (XLI) rising 7.6%, and its technology counterpart, the Technology Sector SPDR (XLK), posting a 5.9% gain. Both sectors should continue to benefit from the increased capital spending currently driving the economy, Krause says.

He explains, “Both sectors are seeing increasing margins, steady or positive revisions to earnings estimates, and improving return on equity — a key driver of valuation and an indication that firms remain disciplined in their use of shareholders’ funds.”

Caveat Emptor: Consumer and Energy Sectors

Krause advises investor caution for both the Consumer Discretionary and Consumer Staples sectors, where earnings estimate are in free fall. Both sectors trailed the S&P 500 in the first quarter, with the Consumer Discretionary Sector SPDR (XLY) gaining 3.1% and the Consumer Staples Sector SPDR (XLP) up just 1.3%.

“After a few years of exceptional earnings growth, analysts have become way too optimistic on consumer-related stocks,” Krause says. “As a result, companies are not able to live up to high expectations.”

As for the energy sector, the outlook is far from certain, according to Krause. The Energy Sector SPDR (XLE) was the top performer for the first quarter, posting an 8.1% return; however, its volatility makes this sector a risky bet for conservative investors. In 2006 alone, XLE rose 14.6% in January, gave back 8.1% in February, and ended March with a gain of 3.9%.

“Although record profits have led to astounding growth in the energy sector, its volatility has increased to the point where it seems more of a speculative than a fundamental play,” Krause notes.

Upward earnings estimate revisions have slowed recently, suggesting that the market has adjusted to the reality of higher oil prices. If crude oil goes to $100 a barrel, as one analyst has suggested, earnings estimates will rise with prices, but with so many geopolitical factors involved here, confidence in any direction is difficult.

“If oil prices go up, investors without exposure to the sector will miss gains,” says Krause. “However, if prices fluctuate without taking a clear direction, the shares could remain quite volatile. And if they go down, energy company earnings and XLE share prices could go down with them. So conservative investors may want to avoid this sector for the time being.”

Energy-averse investors should be mindful that if they own a broad market index such as the S&P 500 (SPY) or the S&P MidCap 400 (MDY), they have energy exposure in the area of 10%.

“One way to limit this exposure is to sell short XLE in an amount equal to 10% of the holdings in the broader indices,” Krause points out. “That way, any losses on the long side will be offset by gains in the short position.” Selling short without an offsetting long exposure is recommended only for investors who specifically want to speculate that oil prices and energy sector profits will decline and are prepared to pay the price if they are wrong.