What does the current market environment favor? One sector is financials, as measured by Financial Select Sector SPDR ETF (XLF) and iShares U.S. Regional Banks ETF (IAT), which are up by approximately 5 percent and 8 percent, respectively, this year.
There are a few important lessons I’d like to share with investors about rising interest rates, which typically favor financial stocks.
Higher interest rates are not a death knell for stocks. There are an infinite amount of factors that drive stock prices. But one thing that a rising-rate scenario does do is change the pecking order of winners and losers, regardless of how long a prior pecking order lasted. When the interest-rate regime changes, everything else changes. In other words, nothing that pays a good yield is safe, and anything that’s safe doesn’t pay a good yield.
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Some stocks, like technology in general and FANG stocks in particular, are more about capacity than interest rates. During the tech stock boom of the late ’90s, the tech sector was driven largely by hardware and semiconductors — Cisco and Intel to name two. But when oversaturation in tech products came about, earnings got crushed, leading to the tech wreck in 2000. Could social media, search and cloud computing become oversaturated in the future? Of course, but that’s a risk all tech investors have to live with. But investors obviously don’t see that happening anytime soon, which is why the tech sector, as measured by Technology Select Sector SPDR ETF (XLK), was able to transition from 2017 into 2018 and still remain an outperformer YTD, up almost 7 percent at the end of February.
Just like that phrase cited above about past performance, diversification is another lesson that many investors seemingly forget during bull markets. If one had an investment portfolio made up of all of the above safe-haven assets/sectors, one might think that means one is diversified. Turns out that couldn’t be further from the truth. Diversification just isn’t as easy as it sounds.
What you really had were a bunch of holdings that were all correlated to the same set of circumstances — a prolonged period of low interest rates and investors piling into the same dividend and interest-paying securities.
I’ve seen this movie before. When interest rates rise, it’s always the same group of conservative investors who were overreaching for yield who wind up getting burned.
— By Mitch Goldberg, president of investment advisory firm ClientFirst Strategy