Bank Stocks Are Working When Their Focus Is the U.S. Economy

  • Russell 2000 financials up 7.8% in 2016, S&P financials down
  • Small-cap financials nearing all-time high as U.S. stocks gain

One of the quietest success stories in this year’s equity rally is small U.S. financial companies, on track to set an all-time high even as their larger counterparts languish.

Boosted by higher earnings and dividends, the Russell 2000 Financial Services Index has jumped 7.8 percent this year, extending an advantage in place since late 2014 in which investors have favored domestically oriented banks shielded from global turmoil. The divergence now is the widest in four years, with small-cap financials rising and large-cap banks down 0.8 percent.

“With the markets hitting new highs, risky assets like small caps have been able to bounce back much better and quicker,” said Michael Arone, the Boston-based chief investment strategist at State Street Global Advisors’ U.S. intermediary business. Small-cap financials are closing in on an all-time high from 2007, trading just 1.8 percent below, while large-caps are 37 percent below their record peak. The S&P 500 financial sector rallied 0.2 percent, while Russell 2000 shares climbed 0.1 percent at 9:43 a.m. in New York.

While the broader Russell 2000 Index also is leading the S&P 500 Index this year, the outperformance is more pronounced in financial stocks. The relative strength of small-cap financials is the second highest among major industries.

Differences between the groups have been accentuated in a year marked by overseas drama such as the U.K. secession vote and China’s currency devaluation, and it’s likely to continue, Arone said. The resilience of the U.S. economy and consumers will disproportionately benefit smaller banks, he said. U.S. employers added the most jobs last month since October, helping dispel concerns that economic growth is slowing.

“We’re seeing the domestic economy acting much healthier than those overseas,” said David Joy, the Boston-based chief market strategist at Ameriprise Financial Inc., which oversees $776 billion. “When the economy is doing well and the markets rally, financials tend to be moving in a positive direction as well and that especially benefits those smaller-cap or regional companies.”

Bank stocks in the Russell 2000 are forecast by analysts to increase earnings by 22 percent this year and 11 percent next, compared with 6 percent and 10 percent for those in the S&P 500, data compiled by Bloomberg show. In the small-cap index, financial stocks trade for 21.3 times earnings, compared with 15.6 for their larger brethren.

The year-to-date rally has seen American Independence Corp., RMR Group Inc. and Crawford & Co. more than double, while the best-performing large cap, Iron Mountain Inc., tops out at 53 percent. The smaller stocks also have higher dividend yields, at 3.3 percent versus 2.3 percent. Payouts have been embraced in a year when bond yields have tumbled to record lows.

Meanwhile, the prospect of lower-for-longer interest rates has proven frustrating for investors hoping that the largest financial stocks could break out of a two-year funk. The implied probability of a rate hike by year-end, now at 46 percent, is down from odds of 92 percent in January, according to Fed funds futures tracked by Bloomberg.

Bank stocks big and small are likely to be the beneficiaries of money managers embracing the industry after shunning it the last few months, Joy said.

“Financials have been suppressed and underweight this year,” said Joy. “But the way the market is shaping up, financials as a whole will do much better in the second half, and that would definitely move and carry the small caps to new levels.”

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