The banking sector and other financial-services businesses have come a long way since the financial crisis. Banks are much better capitalized, they have much higher asset quality as a whole, and they are generally operating as pretty sound businesses.
One way to get some exposure to the banks is through an exchange-traded fund like the Financial Select Sector SPDR Fund (NYSEMKT:XLF). Not only does this take out the guesswork that comes with choosing individual stocks, but it balances your risk level with exposure to both rock-solid companies like Berkshire Hathaway and Wells Fargo and higher-risk names like Citigroup and Bank of America with higher reward potential.
Here are three reasons the financial sector could perform very well in 2015.
If the market's record performance continues
Other than the obvious correlation between good market performance and rising stock prices, there are a few reasons that a record high stock market is a good thing for the financial industry.
For starters, M&A activity and equity underwriting (i.e., IPOs) have both been exceptionally strong this year. One of the leaders in the investment banking space, Morgan Stanley, saw its M&A revenue rise by 43% year over year. Equity underwriting revenue did even better, nearly doubling since last year.
Basically, when the market is strong, private companies are more likely to issue IPOs, as they can get higher prices for their shares. And by the same logic, companies are more likely to agree to buy and sell entire companies. The company being acquired can usually command a higher premium for its shares, and the acquirer generally has easier access to financing if its market value is elevated.
Additionally, the value of a bank's brokerage assets increases as the market does better, which means more fee income. For example, Bank of America's Global Wealth and Investment Management division saw account balances increase by 8% since last year, which was partially responsible for a 19% boost in asset management fee income.
Oil's decline might be good for lending activity
There are several reasons that the recent plunge in the price of oil is bad news for the banks. For one, energy companies are some of the largest issuers of high-yield (junk) debt.
However, there is one reason banks could do well if oil stays cheap. When consumers spend less at the gas pump, they have more disposable income to spend. And if consumers want big-ticket items like cars, houses, boats, etc., they'll need loans. For many other purchases, consumers use their credit cards.
With more money in their pockets, people are more comfortable taking out loans and using their credit cards, because if a family now spends, say, $100 less on gas per month than it used to, it now can use that money toward discretionary spending.
Now, I'm not sure whether this increase in consumer activity could make up for the negative implications of cheaper oil. It's just a fact of life that when people save money in one area, they tend to spend more in others.
Share prices haven't reflected progress made
Even in the past few years alone, banks have done a great job of improving their business fundamentals.
As one example, after the financial crisis, Citigroup stashed its bad "legacy" assets in a new division called Citi Holdings. As recently as 2011, the division held $290 billion worth of high-risk assets. Today that number is down to just $103 billion. Admittedly, $103 billion in risky assets is still substantial for a company whose entire market cap is about $164 billion, but there has been tremendous progress made.
There are similar stories of progress across the industry. Yet despite this progress, banks still trade at roughly the same valuation as they did three years ago.
While some of the pre-crisis valuations were probably a bit inflated (especially in Bank of America and Citigroup's cases), it seems reasonable that shares deserve to be valued at a premium compared to where they were in 2011.
And now, with the majority of the legal fallout from the crisis in the past, it may finally be time for the market to start valuing these companies a little higher.
The banks could make you some serious money if things go well, but be cautious
Now, I'm not suggesting that you should throw a disproportionately large portion of your money into the financial sector. I'm not even saying that any of the above will happen. Rather, these are reasons banking could perform very well. And if it does, investors stand to make a lot of money, especially with the banks trading at such low valuations right now.
Still, more potential reward comes with more risk. Tread cautiously. But if you think any of the above scenarios will happen in the near future, the Financial Select Sector SPDR Fund could be worthy of consideration for your portfolio.
Matthew Frankel owns shares of Bank of America. The Motley Fool recommends Bank of America, Berkshire Hathaway, and Wells Fargo. The Motley Fool owns shares of Bank of America, Berkshire Hathaway, Citigroup, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.