Financials and Energy Stocks May Have Upside Potential, XLF and XLE Look Attractive

XLF AND XLE OUTLOOK:

• The U.S. economy is going through a rough patch, but the situation should improve in the last quarter as delta-variant fears recede
• As the recovery stabilizes, some cyclical stocks could start to outperform. Two sectors with compelling risk/reward profile over the medium-term are financials and energy
• The bullish thesis in these sectors could be played via long exposure to XLF and XLE

The U.S. economy is decelerating, there's no denying it. Household consumption is slowing as fiscal support wanes and delta-variant concerns make consumers more cautious. All of this will lead to softness in the data and disappointment this quarter. However, there is no reason to panic and run for the exits, as activity should improve in the last three months of the year as pandemic anxiety begin to fade, the labor market continues to gain traction, and businesses rebuild depleted inventories. When all is said and done and the dust settles, the economy should grow well above trend through 2022, a good outcome for corporate profits.

The sustained recovery, as we move through the mid-cycle, should support cyclicals at the expense of defensives, especially those with value characteristics and high fundamental dislocation. That said, there are two trades that I personally like with an attractive risk/reward profile: financials and energy. Given that both sectors are currently trading at a discount to the S&P 500, they are well positioned to take advantage of a cyclical relief. At the same time, their cheaper valuation also implies less downside potential in the event of a general market correction.

FINANCIALS

Forward price-to-earnings ratio for the S&P 500 is roughly 22. Meanwhile, for financials, the metric stands at 14.4, a sign that the sector may be undervalued in relative terms. In addition to valuation, there are other bullish catalysts at play at the moment.

First, the increase in buybacks and dividends should create a constructive backdrop and lure more investors. Second, the somewhat positive outlook for Treasury rates is also a tailwind. As the recovery stabilizes and excessive pessimism recedes, bond yields should resume their ascent with more conviction, especially as the Fed tapering announcement approaches. For reference, the 10-year yield currently stands at 1.35%, but is expected to end the year near 1.80% according to the latest Reuters poll.

The historical playbook shows that banks and consumer finance companies perform well in periods of curve steepening and rising yields. This should leave financial sector-oriented ETFs, such as XLF and VFH, in a good position to command strength in the final months of the year.

XLF DAILY CHART WITH KEY TECHNICAL LEVELS

ENERGY

Energy stocks took a beating from early June through mid-August. Some of them fell so much that they reached lows not seen since the beginning of the year, when vaccines were just beginning to be distributed. In recent weeks, however, shares have begun to bounce back following outstanding second quarter corporate results, narrowing the disconnect between the sector's performance and oil prices. Despite this recent small rebound, the sector remains very cheap, trading at 13.2 times forward P/E.

Turning to earnings, many companies in the sector posted billions in income, raking their highest profits since the onset of the coronavirus. Strong corporate performance has hastened buybacks and accelerated cash return to shareholders in the form of attractive dividends, creating a positive backdrop for the sector, at least in principle. Over the medium-term, investment discipline after years of wasteful capital allocation, faster debt reduction targets, increased cash payouts, premium free-cash-flow (FCF) yields and rapidly improving balance sheets in the midst of a supportive oil price environment should reignite momentum and drive stocks higher. To limit company risk, the bullish thesis could be played via XLE (XOP, with more E&P exposure, is another alternative, but likely riskier due to its higher beta to the market).

XLE DAILY CHART WITH KEY TECHNICAL LEVELS

Written by Diego Colman, DailyFX Market Strategist