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Financial Services' Debits and Credits

By Beth Piskora How did financial-services outfits fare in the final quarter of 2004? It was a decidedly mixed performance. On the plus side, large-cap banks, transaction processors, brokerage firms, and asset-management companies generally exceeded S&P's expectations. But regional banks and trust companies presented a less consistently optimistic picture.

S&P continues to recommend a market weighting of this sector, the largest within the S&P 500, accounting for slightly more than 20% of the market cap of the index. "While earnings were good, investors appear to be viewing the sector with caution because much of the earnings growth came from reserve releases or other short-term events, not top-line growth," says Cathy Seifert, head of financial services equity research at S&P.

ATTRACTIVE DIVIDENDS. This sector contains an array of different industries, each with relatively disparate interest rate risk and economic sensitivity. S&P's analysts are most bullish on the prospects for diversified banks and most negative on insurance brokers.

"The macroeconomic trends that we are closely following this year include the pickup in merger and acquisition activity, increased trading on Wall Street, and the Federal Reserve's ongoing series of rate hikes," says Seifert. "We also see a move by investors to higher-quality, dividend-paying stocks. Of the 80 financial services stocks in the S&P 500, 78 pay dividends, with an average yield of 2.3%."

Large-cap banks generally met S&P's earnings estimates, with results supported by continued strength in credit quality, which allowed for moderate releases from reserves. S&P expects earnings growth in coming quarters to be a bit slower, mainly due to the likely absence of reserve releases, but it thinks earnings quality will be better for the same reason.

Regional banks mostly met or beat consensus numbers, although many Wall Street estimates were lowered in the weeks before the earnings reports. These stocks are off to a rough start this year, and S&P thinks they could continue to trade in a tight range for the near term.

TRADING UP. Revenue growth at credit-card issuers was very strong, partly due to seasonal factors. Credit quality remained robust, in S&P's view. The industry is a lot more consolidated than it was a decade ago, and companies are pursuing diversification strategies by expanding into other consumer-finance segments such as home-equity, small-business, auto, and student loans. S&P believes these companies should show improvement in 2005 as they gain share in their new markets.

Investment banks, brokerages, and asset-management companies garnered strong profits and generally exceeded our expectations, aided in part by solid equity markets, continued net client inflows, healthy fixed-income and equity-trading revenue, and a seasonal rebound in retail trading volumes.

Many firms remained focused on prudent expense growth, particularly in the area of compensation, which led to generally improving operating margins. Despite a flattening

yield curve and a weak equity market thus far in 2005, S&P expects strong results for the full year driven by expectation of generally improving investor confidence by the end of the year.

WARY EYES. The stock prices of insurance brokers rebounded off their lows following the announcement of New York Attorney General Eliot Spitzer's investigations in October but generally ended 2004 below their highs for the year. Few have yet reported their quarterly earnings, and S&P remains negative on the group.

Results for property and casualty insurers were aided by a strong pricing environment in 2004, which appears to be waning as 2005 unfolds. Despite the high level of catastrophe losses in the fourth quarter, underwriting results were aided by unusually favorable noncatastrophe loss trends. However, S&P believes investors are casting a wary eye toward these results, because the favorable trends may not be sustainable.

While its overall outlook on the sector is neutral, S&P does have a number of 5-STARS (strong buy) recommendations in the group, including Allstate (ALL

; recent price, $52), Bank of America (BAC

; $47), Bear Stearns (BSC

; $102), Citigroup (C

; $50), E*Trade (ET

; 13), Franklin Resources (BEN

; $68), Goldman Sachs (GS

; $110), MBNA Corp. (KRB

; $27), and U.S. Bancorp (USB

; $30).

Investors who wish to gain broader exposure to the sector might want to consider exchange-traded funds like Select Sector SPDR-Financial (XLF) and iShares S&P Global Financial Sector (IXG). Piskora is senior editor of Standard & Poor's weekly investing newsletter, The Outlook

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