The financial sector took a battering in the 2008 crash which led to at least two major headwinds for financial stocks:
- Financial companies became highly regulated. New laws came in that prevented banks and other institutions from making the big profits they were used to.
- Quantitative easing caused interest rates to drop to record lows. Although low rates are not the end of the world for financials the banking sector generally makes more money when interest rates go up.
It’s for these reasons that financials have not been able to make the kind of mouth watering returns that they did before the crisis.
However, financials are far from being market laggards.
Over the past five years, financials have returned +46.81% putting the sector behind only technology, consumer discretionary and healthcare:
Despite these decent figures I always have trouble pulling the trigger on a financial stock.
I previously thought this was due to my inherent distrust of the sector but as it turns out, my skepticism has some legs to it.
The following chart shows the backtest results for a momentum system I’m working on based on a selection of US small cap stocks:
The chart above translates to an annualized return of 28.64%, a maximum drawdown of -26.21% with a win rate of 41.61%.
Now you can see what happens when I take the same momentum system but exclude all financial stocks from the test:
Annualized return has risen dramatically to 32.48%, maximum drawdown has dropped to -23.32% while win rate has dropped to 40.8%.
Excluding financial stocks we ended up with a final equity of $141,852 whereas previously we had finished on $112,163.
And this is without including years 2008 and 2009 which saw many financials go to zero.
Greenblatt Ignores Bank Stocks Too
Joel Greenblatt’s Magic Formula is one other well known strategy that ignores financial and utility shares. From my own analysis I think there are good reasons why.
Both these sectors tend to produce steady, slow returns.
It’s rare to see a banking stock jump twenty or thirty per cent for example but that can be the norm for some biotechs.
From a trend following perspective, grabbing a few of these big winners can make a big difference to your final profits.
Healthcare and technology stocks are risky of course but with that risk comes the opportunity for greater reward.
Financials (and utility stocks) on the other hand do not have the same assymetric risk to reward.
If anything, risk is skewed to the downside in banking since bank stocks are often highly leveraged. This is what we saw play out in the 2008 crash.
No More Bank Stocks For Me
I will be avoiding financial stocks in my momentum trading unless I find new evidence to the contrary.
Tomorrow’s momentum pick is not a bank (surprise surprise) but MODN.
Model N Inc is a technology stock breaking out to new highs and also saw some insider buying last week. This is NOT a tip but I will be going long in the morning.
Charts produced with Amibroker using data from Norgate.
Thank You For Reading
Joe Marwood is an independent trader and the founder of Decoding Markets. He worked as a professional futures trader and has a passion for investing and building mechanical trading strategies. If you are interested in more quantitative trading strategies, investing ideas and tutorials make sure to check out our program Marwood Research.
This post expresses the opinions of the writer and is for information or entertainment purposes only. It is not a recommendation or personalised investment advice. Joe Marwood is not a registered financial advisor or certified analyst. The reader agrees to assume all risk resulting from the application of any of the information provided. Past performance, historical or simulated results are not a reliable indicator of future returns and may not account for real world settings. Financial trading is full of risk and margin trading can lead to financial losses totalling more than what is in your investment account. We take care to present accurate analysis but mistakes in backtesting and presenting of analysis regularly occur. Please read the Full disclaimer.
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