Commodities may be the new new thing, but life in the financial world isn’t doing so badly either. In fact, financial stocks have enjoyed a strong run in recent years. The question is whether things can get any better for finance?
For the moment at least, it’s easy to say that more of the same is coming, a perspective that finds support by looking in the rear-view mirror. For the year through last month, for example, the S&P 500 Financials Spider ETF (XTF) ranks second in performance among the nine sector Spider ETFs, posting a total return of 17.1%. Only the S&P 500 Energy Spider (XLE) boasts a better record over that 12-month stretch, rising by 28.3%.
Delivering above-average gains at a time when interest rates are rising is no mean feat for financial stocks. In theory, an industry that thrives on cheap money should be hurt when liquidity starts to fade. But evidence in support of that textbook notion is scarce. Indeed, XLF has recently been making new highs–hardly the sign of anxiety about the future.
What’s more, Wall Street expects the robust earnings rise in financial stocks to continue for the foreseeable future. AltaVista Independent Research, an ETF-focused shop, points out in its latest report to clients that “financial earnings are the fastest growing of any [S&P 500] sector in 2006.” The good times are predicted to continue in the second quarter, for instance, with XLF’s year-over-year percentage change in earnings forecast to rise 10.5%, according to the consensus outlook. That represents a respectable third place in relative terms, coming after energy’s expected 17.6% rise and utilities’ 17.5%.
None of this comes as a surprise to the bulls. Wall Street, after all, has rewarded financials past record handsomely. Financials remain by far the biggest slice of the S&P 500 sectors in terms of market cap, representing more than one-fifth of the benchmark.

One of the various arguments for expecting financials to keep bubbling is the prediction that mergers and acquisitions will remain robust, both generally and within the financial services sector. If so, the trend promises to create more business for the largest firms in XLF, while at the same time driving up the stock prices of smaller players as the bigger fish gobble them up as strategy for growth.
Perhaps, but it’s also true that there are strange things unfolding in the bull market for financials. Consider the world of merger arbitrage, a business where the shares of the acquiring company traditionally fall in price on the logic that shelling out money to buy other firms is a short-term strain on earnings. Meanwhile, the target stock tends to rise after the announcement of an approaching acquisition makes the headlines. It’s this standard that’s keeps many a merger arb fund in the black by allowing a modest profit to be had from “the spread,” generated by shorting the acquirer and going long the target company.
But that long-standing relationship has been turned on its head lately, according to Frank Yeary, who heads up global M&A at Citigroup, the largest company in XLF. According to a story in The Economist (subscription required), Yeary explains that doing takeover deals has in fact been good for share prices. He reports that those S&P 500 stocks have engaged in takeover bids of $1 billion-plus have delivered above-average returns in the last three months. So much for earnings strain by way of spending money.
There are other odd trends afoot in finance, for anyone who cares to look. For instance, consider that while the Fed is trying to instill a bit more modesty when it comes to borrowing, the private sector has the luxury of thumbing its nose at the ancient institution. Indeed, credit growth in the U.S. has been growing at a much faster rate than broad money-supply growth, notes Lombard Street Research in a report from earlier this week. The force behind much of this private-sector credit growth is capital inflows from abroad. In time, the divergence between credit growth and money-supply growth must converge, LSR advises. Ah, but the timing depends on when and if foreigners decide to reallocate money elsewhere, an act that would then pinch credit growth. Maybe.
In the meantime, liquidity is king, and that’s been a boon for the financial sector. The Fed may be intent on sobering up the likes of Citigroup, but to date that effort has been less than successful. The financials like their punchbowl, and there’s no indication that Bernanke and friends are up to the task of taking it away. Well, almost no indication.
The 10-year Treasury yield crossed above the 5.0% mark this morning for the first time in nearly four years. That seems to have attracted the attention of stocks, which are slumping this morning. But the bellwether of financials, Citigroup, isn’t blinking. Shares of the financial conglomerate are up this morning, bucking the trend in equities so far today. Momentum doesn’t last forever, but it can roll on longer a lot longer than you might expect.