Time to Allocate More to Financials

 | Dec 03, 2013 | 10:00 AM EST
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I saw Stephanie Link on Power Lunch on CNBC Monday. I like and agree with her take that financials and industrials should outperform the overall market in an environment of rising interest rates. I think this observation is important as continuing rising interest rates in 2014 are looking more and more probable.

Pundits may disagree with when the Federal Reserve will start to "taper" but all the signs are pointing to that event sometime in the first half of 2014. Some of this rise has already been anticipated by the market as the yield on the -year Treasury has already risen from 1.6% in May to a current 2.8%.

As the Fed gradually withdraws its largesse and the economy continues to improve, interest rates should slowly rise. This should improve the prospects for the financials. Banks should benefit as net interest spread margins improve -- remember the Federal Reserve has pledged to keep the short-end of the yield curve at very low levels for the foreseeable future. The rise in interest rates should also be positive for insurance companies as returns from their investment portfolios improve.

The action in the financial sector recently is starting to reflect this view. After slightly underperforming the market over the previous six months, Financials have roughly doubled the overall return of the market over the past month (See Chart).

In response to this shift and the prospect of higher rates in 2014 I am slowly moving my own portfolio from an "underweight" position on financials to "neutral". I plan to add some financial stocks to my portfolio over the coming few weeks to attain that allocation shift.

I added Hartford Financial Services Group (HIG) on Monday. This insurer should benefit as interest rates rise in 2014. I also like the progress it has made in restructuring its enterprise and I think its turnaround will continue to bear fruit.

Hartford put its individual annuity business in runoff mode last year and it also recently announced the sale of its individual life, retirement and other assorted non-core financial units. This leaves Hartford better able to focus on its remaining property-casualty, group benefits and mutual fund operations.

Hartford is not expensive at less than book value and around 10x forward earnings. The stock also sports a 1.7% dividend yield and the company has over $800 million left in an active stock repurchase program. I also like the fact that insiders have a significant stake in the company and have held onto their shares tightly even as the stock has run up some 50% this year.

In addition to Hartford I continue to positive on the prospects for insurers American International Group (AIG) and AEGON N.V. (AEG). Finally, I will be taking a look at adding Citigroup (C). I like the progress the bank has made under its new CEO over the last year. The stock also sells at under book value, goes for less than 10x forward earnings and the bank seems to have remained a lower profile target for federal regulators than competitor JPMorgan Chase (JPM).

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