Just take a look at the various sub-industries here and see what's happening. When we talk about the big, broadest, most widely held financial sector ETFs, we are talking about the Financial Sector SPDR, the XLF, the Vanguard Financials, the iShares Dow Jones US Financials, when we look at these, there is actually a pretty common breakdown in the sub-industries is how they look?
Burns: OK. So, it is kind of spread out and even inside those industries are sub-industries and of course those figures we were giving are approximations, because each of the different funds holds a little bit more this or that. But in general, let's take a look here at the first set of sub-industries, the super sub-industries, maybe the banks here. So, when we take a look at banks, that's 50 percent of the broad equity holdings out there--where are we right now in terms of valuation when we aggregate what our equity analysts say?
Gabriel: Right. We are at about 90 percent price to fair value, so with the uncertainty that remains in this sector, it is not as attractive on a risk-reward basis. I mean a lot of the easy money has been made and that's pretty clear. We have seen stocks quadruple of their bottom. So, that's a sector you probably want to approach with a little bit more caution.
Burns: OK. So, as we walk down in terms of the broad indexes, the next big sector is going to be insurance. And no sector has really rallied as furiously as insurance has. When we look at the KBW Insurance Index, it is up 104 percent over the past six months, which is a furious rally amongst a bunch of other furious rallies. So, what has really been behind that?
Gabriel: Well, those companies are interestingly levered to the stock market so they benefited from the strong stock market rally over the past several months, where if you think about the variable annuity portfolios and a lot of that money being invested in stocks now. As they are assets under management or AUM grows, they can generate more fee-based incomes.
Burns: OK. So, we have had a tremendous rally, but is this sector out of the woods yet or what are we looking at here?
Gabriel: It is certainly not out of the woods, actually on a price to fair value basis, I think it is pretty fairly valued, maybe even a little bit, a touch overvalued, but something to consider there is as we look at our stock research, we have a very high uncertainty. In fact 20 percent of the portfolio of the insurance index we have it rated as "extreme," which means we can't confidently peg a fair value for those companies.
Burns: And usually, just so people watching understand that an extreme rating means that we are probably looking at binomial outcome of either very impaired stock value or something that they make it through the storm, so a 20 or a 2, and that's usually what drives an extreme value. So insurance, it doesn't look like the risk-reward is there right now, the rallies kind of happen, and still maybe actually look for a leg down potentially.
Gabriel: Right. So, if you have enjoyed that rally, you might be thinking maybe to take some off the table let's say.
Burns: Right. So, when we look at the next sector, capital markets 20 percent, it is kind of ironic because we still include names like Goldman Sachs, Morgan Stanley in there, at least in the classification systems, although they are now technically banks. But, when we look at capital markets, Goldman put up some very impressive numbers recently. Is this something that we have got a lot of interest in right now?
Gabriel: It is interesting and definitely drove results in the second quarter there, but one thing to remember is that this was an extreme period in the stock market in fixed income markets, and we had extreme volatility, which means wider bid-ask spreads, which means the trading operations at those companies really made a mint last quarter and that's not something we expect to go forward and investors shouldn't either.
Burns: Right. So, not all businesses were hurt by the volatility. When we look at the trading platforms of even like a Merc or a New York Stock Exchange and even a Goldman and a Morgan Stanley, I mean they all benefit from all that uncertainty, at least the trading operations.
Gabriel: Right. And that's part of the intrigue of the I-bank model or the former I-bank model was the diversity of operations within them. So, when one business performs poorly, they can make it up on the trading, but that also leads to uncertainty in the forecast going forward, too, so we can't except the heydays to go on forever.
Burns: So, it sounds like in terms of capital preservation, or worry about collapse, that's not really there, but you know what's really hard to gauge right now is what's kind of that long-run business model, what's that long run cash flow for the sector as a whole?
Gabriel: Normalized earnings rate.
Burns: So, maybe some headwinds just as the market seems to calm down, well let's hope it stays calm.
Gabriel: And I would just add too for the capital markets groups, you do have asset managers in there and brokerages which do... assets under management is the big ticket there--that's the business model. We look at it as a levered play on the market as well, too.
Burns: Then we have REITs, that's the last section. The commercial real estate sector has a little bit of uncertainty right now, I mean what's going to be the key driver for REITs going forward?
Gabriel: Well, it is going to be asset prices. It is a matter of liquidity, too, so the availability of credit, a lot of those REITs have a lot of debt coming due that they need to roll over to maintain their operations, so that's why we have seen a lot of REITs start to payout their dividends with stock instead of cash as they try to build those reserves in order to roll over that debt and meet their needs.
And so, there is again with the banks, there is a big bifurcation between the weak and the strong, but asset prices, rents, things like that, and then within REITs, they are exposed to different industries. Health-care REIT right now might be a relatively safe place to be, that's about 10-12 percent of those indexes, but offices and...
Burns: Right. I mean really sounds like this is more of a levered play in the economy and consumer spending and office renting; I mean things that have really stabilized and are showing some signs of life there. So, maybe some of the risk is coming off the table as long as that credit can stay loose.
Gabriel: Some of the risk coming off the table, but at the same time the stocks have rallied and are anticipating that the stabilization is here to stay. So, in the case of a double dip, all bets are off, look out below.
Burns: Yeah. Well, I think that'd be probably the worst way to celebrate the anniversary as Lehman collapses with another double dip. Well, thanks for joining me John.
Gabriel: Thanks.
Burns: I'm Scott Burns with Morningstar's ETF Research. For this and other ETF Research data and tools, please check out Morningstar.com. Thanks.
