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Six warning signs to heed before buying financial stocks

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Peter Topp Enge Jonasen | Getty Images

As the worst-performing sector this year, financial stocks might make a tempting target for investors looking for value.

However, one market pro is advising caution against buying the group, which is one of only two S&P 500 sectors notching negative returns year to date.

Nick Colas, chief market strategist at Convergex, notes that not only have financials lagged the broader market in 2016, but they also remain the worst performer of the S&P's 10 sectors over the last 10 years, declining 29 percent during the period. Excluding real estate investment trusts, which have gained 28 percent on a price basis, the industry would be down 33 percent. Financials were off 1.4 percent year to date heading into Wednesday's trading.

Financials "face several powerful headwinds and a few crosscurrents to boot," Colas warned clients in a note that outlined six signs investors should heed before diving into the sector:

  • 1. The financial stocks "have been dreadful investments." Of course, what happened in the past doesn't always presage the future, but if the trend is your friend, then financial stock buyers could become castaways.
  • 2. Regulation: The Fed will be releasing stress tests results on June 23 with the related Comprehensive Capital Analysis and Review results out six days later. "In any given year, at least one institution has been singled out for deficiencies and the 2016 reviews will likely follow that precedent," Colas said. And, of course, there are the Dodd-Frank regulations and a generally hostile air in Washington toward big banks.
  • 3. Low expected returns on capital: The average return on equity for large banks is 9 percent, but the price-to-book level averages 1.1 times, meaning investors have low expectations for growth.
  • 4. Cost of capital: Colas found that financial stocks on average are 20 percent more volatile than the S&P 500 broadly (examining how the sector has traded against the index). The upshot: "Investors rightly worry that banks have a very high cost of capital ... relative to their current returns. "
  • 5. Oil prices: Those looking for banks to rebound as oil prices climb out of a bear market are likely to be disappointed. Colas' team found little correlation and believe financials are "poor proxies for moves in the energy market."
  • 6. "So what else could happen?" Among other things, Colas is skeptical that a new wave of professionals will be able to turn around the performance of financials.

"The key takeaway from both this final point and the piece as a whole is that financials will likely remain a tough place to make outsized returns," Colas wrote. "Regulatory burdens are a piece of that, to be sure, and in the absence of a change in Washington that drag seems likely to continue."

The note mostly avoids the role the Fed will play with bank stocks. There's expectation that as the central bank normalizes rates, bank performance will follow. However, recent indicators are that the Fed is no hurry to raise rates, keeping bank returns in check.

"In the end, the resurrection of this group will have to come from one place, and one place alone: all those clever people who run the companies," Colas said. "There is an old saying on Wall Street that the most important assets of a bank go up and down in the elevator every day. Perhaps one day they will find the 'up" button again."