I have a confession…

I hate talking politics. It pains me to have to pay attention to a bunch of old men squabbling in D.C.

But the fact of the matter is, government has gotten so big, we—as investors—can’t ignore it.

The government is directly responsible for a large chunk of the economy. Its spending alone makes up over 20% of U.S. gross domestic product (GDP). Indirectly, it affects the whole economy. After all, politics moves investor sentiment, and sentiment moves markets.

Nowhere can we see this better than in the financial sector. While financial firms aren’t a part of the government… regulations can affect how profitable they are.

Case in point: Yesterday, we showed you how financial stocks have more than doubled the return of the S&P 500 since the election. This surge occurred on hopes that Trump’s administration would cut banking regulations. And less regulation means more profits for banks.

As the political mood turned after the election, financial stocks shot up over 20%…

You might be wondering if you missed the rally. You haven’t. In fact, banks are cheap compared to their historical average… and where they traded in 2007.

Plus, if you can manage to see through the political racket, you’ll find an opportunity ripe for investment.

Banks Are Far From Bubble Territory

In the chart below, you’ll see the value of the S&P 500 Financial Index since 1990. You’ll notice I included the price-to-book (P/B) ratio. The P/B ratio measures the price of the stock against the value of the company’s assets. This is the most important valuation metric for financial stocks—big investors in this space care more about price-to-book than any other ratio for financials.

The red line in the chart below is the average P/B ratio over the last 27 years. Note how financial stocks are still well below that line…

Also note that financial stocks are below the 2007 valuations banks had pre-Dodd-Frank (the extensive financial regulations passed in 2010 as a knee-jerk reaction to the financial meltdown)… and even further below valuations from the late 1990s.

To get to 2007 levels, banks would have to rise 49%. To get to 1999 levels, banks’ share prices would have to increase 151%.

And that’s assuming banks do nothing to increase their book values…

Why Valuations Will Rise

Valuations of banks should increase for three main reasons.

The first, as we covered, has to do with Trump’s plan for less regulation. Less regulation would allow banks to operate freely and devote fewer resources to compliance.

In fact, the last time Congress repealed major banking regulations was in 1999 when it pulled back the Glass-Steagall Act. The Act limited banking functions by prohibiting commercial banks from getting into the investment banking business, and vice versa. And look what repealing Glass-Steagall did to bank valuations (they shot up in the mid- to late ’90s)…

There’s another reason why financial valuations will rise…

The economy is still growing. Last year, GDP was up 3%. And with the unemployment rate at a low 4.8%, people have the means to pay back loans. Plus, consumer confidence is near all-time highs. When that happens, consumers spend more freely and take out more loans. This environment is perfect for banks.

The third tailwind for higher valuations is that interest rates are rising. When interest rates rise, so do “net interest margins”…

Net interest margin is the difference in rates that banks charge customers for loans… and how much they pay in interest on deposits. The bigger the margin, the more profits for the banks.

Net interest margins usually increase along with interest rates. The Fed said it still plans to raise rates three times this year. If it keeps its word, banks will benefit.

As we mentioned last month, in this stage of the business cycle, we should be looking to exit financial positions…

But we need to make an exception today, at a time when politicians start favoring an industry that’s trading cheaply.

If Trump is successful in cutting regulations, banks will accelerate their profit growth, and we will see valuations and prices follow suit.


Nick Rokke, CFA
Analyst, The Palm Beach Daily

P.S. Banks aren’t the only cheap plays on my watch list right now. Readers have been asking about my top “cheap, elite companies.” More on that… tomorrow.


The world’s largest public company just broke out to a new all-time high.

Apple Inc. (AAPL) jumped to over $136 yesterday, breaking its previous high of $135 set in April 2015.

As it happens, Apple qualifies as one of our cheap, elite companies. It passes the profitability and growth tests easily. However, it’s not on the list right now because it’s not trading cheaply enough.

Over the past four years, this behemoth has doubled in price. This shows the power of holding quality companies for the long haul.

Nick Rokke

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