Stocks dropped significantly yesterday as Treasury yields climbed to new multi-year highs. Given that the Fed is on a path towards even higher interest rates it is only reasonable to expect that we will see more of the same in the coming months, which leaves investors searching for somewhere to hide.
The conventional wisdom, as expressed here, seems to be that banks are the place to be. As a rule, traders and investors should be wary of conventional wisdom but in this case the logic behind that argument is hard to fault.
The traditional business for banks involves lending money at higher rates than they pay to borrow it or attract it from depositors. Higher rates facilitate that and especially when longer term rates climb faster than those at the short end of the yield curve. The recent surge in yields from ten out to thirty-year maturities therefore suggests increased profits at banks and other financial institutions and the assumption that that will push stocks in the sector higher is perfectly reasonable.
That is why, even as the major indices all dropped yesterday, the financial sector ETF (XLF) posted gains. The problem, as is so often the case, is that a lot of the benefit of higher rates is already priced into the financial sector.
The Fed’s actions can hardly be called a surprise. We have known for several years that rates would be gradually increasing and the market has had plenty of time to adjust to that reality. That could result in disappointing returns for investors in broad-based ETFs like XLF, but the resulting volatility in bond and equity markets will benefit some more than others.
Profits at big banks these days are usually more about trading revenue than loan generation, so it will pay to look to places with less exposure to retail banking and more dependence on trading and investment banking such as Goldman Sachs (GS).
Goldman has been an underperformer in recent months, even in the generally underperforming financial sector, but that is exactly why it represents an opportunity now. The benefits of higher rates are not priced into GS as much as some other stocks, giving more of an upside to a long position, and the proximity to the 52-week low allows for a trade with a logical limit to the downside.
Buying here with a stop-loss just below that low of 218.89 would limit potential losses to around five percent while having potential for significant profit should the stock even just adjust back to the sector average.
There is also, based on recent history, a good chance that GS will receive a short-term boost next week. They are scheduled to release earnings on October 11. The last four quarters have seen Goldman beat expectations handily, and more of the same must be on the cards given recent volatility in both the stock and bond markets.
If nothing else, as we approach the earnings release date, buying in expectation of another beat could easily be enough to push GS to a level that gives some protection to a long position, regardless of what the actual numbers show.
It is hard to escape the conclusion that as rates climb, banks will prosper, whether that is due to better results from conventional banking operations or better returns on riskier business such as trading.
Looking for opportunities in the sector makes sense in that situation. Goldman has more room to improve than most and the technical setup gives a good risk/reward ratio to the trade, so it is a logical place for investors looking to take advantage of that to be.