Investors are getting scared again.
On February 3, the S&P 500 fell 2.1% -- its largest one-day drop since June. The pullback sent the CBOE Volatility Index (VIX) -- a gauge used to judge fear in the marketplace -- to 21.4, its highest level in 18 months.
Defensive assets have also been rallying. Treasury bonds and gold bullion are both up more than 4.5% since the beginning of the year. People are likely returning to these "safe haven" assets as they brace for more turbulence in the equity markets.
So should you follow their lead? After all, the S&P 500 gained 32% (including dividends) last year -- its third-best annual performance in two decades. After such a mind-blowing year, surely the pullback is the start of a much bigger correction... right?
For starters, even with the Federal Reserve starting to "taper," the low-interest rate environment that's been fueling the recent bull market is unlikely to change anytime soon. Based on the Fed's Open Market Committee meeting last week, the U.S. central bank plans to keep interest rates at or near zero through at least 2015. Since stock prices and interest rates tend to move in opposite directions, these policies should continue to support higher equity prices in the short to medium term.
OK, that's great... but what about valuations? After last year's historic rally, surely stocks are starting to get a little expensive... right?
Again, not necessarily.
While the S&P 500's current price-to-earnings (P/E) ratio of 16 is higher than its long-term average of 15.5, it's still nowhere near the P/E ratio of 48 we saw during 2001's dot-com bubble. Generally speaking, when the S&P 500 sports a P/E ratio in excess of 25, it's a good sign that stocks have entered a speculative bubble. At 16, it just means stocks are fairly valued...
In other words, based on current fundamentals, there is no reason to think that the recent downturn is the start of another major bear market. Instead, what's far more likely is that the market is simply consolidating after last year's record-breaking run. After all, we haven't had a pullback of 10% or more since June 2011. So there's no doubt we're overdue.
As a result, if the market continues to experience any weakness, consider it an opportunity to pick up any stocks that might be on your radar -- especially in one particular sector...
This Industry Could Be Responsible For More Than Half The Market's Growth
In the February issue of his High-Yield Investing newsletter, Nathan Slaughter told his subscribers why he thinks banks and other financial services companies will be some of the market's strongest performers over the next 12 months:
To understand why the future [for banks stocks] is so sunny, you have to revisit the gloomy days following the financial crash, when the entire industry was in a state of upheaval. Not knowing just how bad things might get, banks began depositing huge sums of cash into special reserve accounts as a cushion to help cover future credit losses should borrowers default en masse on their credit card debt and mortgage loans.
By itself, Bank of America deposited $48.6 billion into loan loss reserves in 2009. The money placed into these accounts not only drained current earnings, but it also couldn't be loaned out or invested to generate future earnings -- a true double whammy.
This situation has reversed almost 180 degrees. New deposits into these accounts have dried up, and older deposits from prior years are being unlocked and released.
These accounting maneuvers have boosted profits above and beyond what the banks are actually earning. More important, these billions are now free to be deployed in new loans or investments. And on that front, they will likely earn far better returns than would have been possible a couple years ago.
As long as reasonable lending standards are maintained and bad loans remain manageable, this is a sure recipe for generating easy profits.
The extra cash and widening profit margins are expected to help banks grow earnings by an average rate of 23.5% this year -- the fastest among any of the 10 major market sectors. Incidentally, if you remove the financial sector, earnings growth for the rest of the S&P 500 would slow from 6.4% to 3.1%.
In other words, financial services stocks are expected to account for more of the market's earnings growth this year than the other nine sectors combined.
And if that weren't enough, there's also another reason Nathan likes bank stocks right now -- dividends.
According to financial research firm FactSet, banks are expected to be the most dividend-friendly industry group (again) in 2014, with estimates calling for average dividend growth of 17.5%, more than double the 8.7% increase expected by the broader market.
One company likely to benefit from this trend is People's United Financial (Nasdaq: PBCT), a New England bank currently paying a 4.6% dividend yield. Here's what Nathan had to say about People's United:
You can tell a lot about a company's financial performance simply by reviewing its dividend track record. And it speaks volumes that when most other financial institutions were slashing (or discontinuing) quarterly distributions during the financial crash, People's United maintained its dividend.
In fact, the company was able to raise its quarterly dividend in 2008 to $0.15 per share from $0.133 per share and again in 2009 to $0.1525 per share. And the company has increased it every year since 1995 (always in April) to the current $0.1625 per share.
The current annual payout of $0.65 per share is throwing off a robust yield of 4.5%. That is more than double the category average of 1.6% and ranks as one of the highest distribution rates in the industry.
Despite these positive catalysts, People's United has been getting a lot of disrespect from the market lately -- losing ground for four straight years between 2009 and 2012. The stock finally started to turn around in 2013, gaining close to 30% on the year. The market has once again turned bearish on PBCT, and the stock is down another 5.6% year to date.
But even after last year's rally and the ensuing pullback, Nathan still thinks People's United has further to run. Based on its recent price around $14.17 per share, PBCT is trading at a 9% discount to its book value and 25% below its five-year high of $18.54 a share.
That's a curious phenomenon considering the company's loans, deposits, fee-based income, return on stockholders' equity, dividends and earnings per share all hit record highs last year.
As Nathan says, generally speaking, "these kinds of disconnects usually spell opportunity."