By Chuck Mikolajczak
NEW YORK (Reuters) - Investors willing to bet the recent signs of improvement in the U.S. economy will continue may want to turn their attention to the beaten-down bank sector ahead of Friday's employment report.
The S&P financial sector (SPSY) is down more than 8 percent for the year, the worst-performing of the 10 major S&P sector groups.
Financials have been hit in the first few weeks of 2016 by recession worries and diminished expectations of an interest rate hike by the Federal Reserve this year. Moves by other global central banks to implement a negative interest rate policy also worked against financial companies.
In addition, bank shares have succumbed to pressure as slumping oil prices have increased concern about their exposure to bad loans in the energy sector.
That has left bank stocks extremely cheap; companies in the financial sector index are selling at 12 times their expected earnings over the next 12 months, compared with 15.7 percent for the broad Standard & Poor's 500 index.
With forward price-to-earnings ratios of 9.6 and 8.2, names such as Bank of America (N:BAC), and Citigroup (N:C), respectively, are still well below average for the industry and their own historical records, even though the sector's shares started moving back up in the second half of February.
"It is unbelievable," said Art Hogan, chief market strategist at Wunderlich Securities in New York. "These are well-funded, under-levered, well-capitalized ongoing businesses that are trading at historically low valuations."
Banks have rallied in the last two weeks, however, as economic data has pointed to an economy that is gaining traction after stalling in the fourth quarter, evidenced by optimistic reports on manufacturing, consumer spending and the labour market.
A strong payrolls number on Friday would bolster that view and increase expectations of a Fed hike, making banks even more attractive.
While many market participants view a rate hike this year as unlikely, many anticipate at least one, with the probability of a rate hike at the December meeting now at 60 percent, according to options and futures exchange CME Group's FedWatch tool, which measures the market's view on the likelihood of changes in U.S. monetary policy.
But banks still have hurdles to climb, a bad payrolls report could dampen the likelihood of a rate hike, while crude is still showing a glut of supply and could resume a downtrend.
More importantly, earnings growth is expected to be difficult for banks. They are vulnerable to further declines in yields and narrowing interest rate margins, according to Bill Gross, manager of the Janus Global Unconstrained Bond Fund.
Most of their near-term growth will come from cost cutting, and investors will have to be "picky" about choosing the right banks shares to buy, said Kim Forrest, senior equity research analyst at Fort Pitt Capital Group in Pittsburgh.
She says investors need to focus on banks that are not only cheap, but have a growth narrative. Forrest currently owns PNC Financial Services (N:PNC) and Bank of New York Mellon (N:BK).
She notes, however, that "You can’t buy the basket."