Financial stocks are inexpensive for a number of reasons. But does that make the group attractive for the average investor, or is the sector still too speculative for most?

Prior to the steep 2007-2009 recession, investors liked stocks of banks, thrifts, insurance companies, real estate investment trusts, and buyout shops for their solid dividend yields, modest upside potential, and the moderate volatility they afforded. (Shares of securities brokerages are more leveraged to stock-market performance.) However, the group’s investment characteristics have changed dramatically in a few short years. Financial stocks, particularly those of banks, are less known for their income generation nowadays, after a number of painful dividend reductions, and more for their wide recovery potential. Volatility has also increased notably. 

The added volatility is in response to the sector’s recent litany of woes, which include increased regulation, real estate litigation, margin compression, subpar economic growth, a weak lending environment, and fears of trouble in Europe. In addition, proprietary trading restrictions are a negative for some. It is simply difficult for investors to get comfortable with a stock market sector that is facing as many issues as this one.  A "once-burnt, twice shy" mentality has also set in for investors who lost money in financial stocks during the 2007-2009 downturn. 

The good news is that shares of many banks and insurance companies already appear to reflect much of the potential trouble if one uses criteria such as low price-earnings ratios and low book value per share. But that hasn’t been enough to spark a persistent rally in the sector. Part of the problem is that some of the issues financial stocks are facing (greater regulation and trading restrictions) are likely to remain in place indefinitely. And other difficulties (mortgage litigation, weak lending backdrop, margin compression, European contagion fears) will likely only clear up in time. That is hardly a recipe for near-term stock-price performance.

So what will it take to rebuild confidence in financial stocks? The short answer is the economy. Steady economic improvement over time will clear up a lot of the woes facing banks as the number of nonperforming loans fall, and as new businesses with a good chance of succeeding are funded. Moreover, improved business conditions would lead to a more normalized interest rate environment. Although the shape of the yield curve is currently considered "normal", with long-term rates higher than short-term rates, it is skewed significantly toward the low end of the curve. That indicates all is not right with the economy. Insurance companies tend to fare better when rates are well off the bottom, since their bond portfolios then generate more income to meet corporate liabilities. Lenders would also presumably welcome a rise in interest rates, if it were to mean greater loan volume. 

Overall, the financial sector is more speculative than in the past, given a host of concerns, the largest of which is the fear that Europe’s troubles could hurt the economy here through another Lehman Brothers-type meltdown. A resolution to Europe’s fiscal problems would provide what could be considered an "all-clear" signal to buy financial stocks of all stripes, but policy-makers on the other side of the Atlantic still have a lot of work ahead of them. The key assumption investors need to make, and it is not an easy one, is that the situation in Europe won’t spin out of control. Under that scenario, the recovery potential of shares of industry leaders, such as J.P.Morgan Chase (JPM - Free JPMorgan Chase Stock Report), Citigroup (C), MetLife (MET), and Wells Fargo (WFC) is extremely tempting. Wells Fargo is planning to ask regulators to let it raise the dividend and buy back more stock after the latest bank stress tests are completed in January.

There are also a few of the good dividend-paying, comparatively low volatility financial stocks of old still available. Texas’ Cullen/Frost (CFR), New York’s M&T Bank (MTB), and Royal Bank of Canada (RY.TO) fit that category. Those three companies all carry above-average Financial Strength ratings by Value Line, and none had to reduce its dividend.

 
At the time of this article, the author did not have positions in any of the companies mentioned.