Tuesday, 30 March 2010

Financial Bubble Still Here with Yet More to Unravel?

Is there such a thing as a secular financial bubble? Has the financial sector become bloated out of proportion to the economy over the last few decades and is there be a contraction in store, abrupt or prolonged, back to a smaller financial sector? Was the crisis of 2008 merely the start?

I'm not sure of the answer but a couple of data points have stuck in my mind recently:

1) Below is a copy of two charts from the paper Fundamental Indexation by Rob Arnott, Jason Hsu and Philip Moore. Note how the Financial sector, both on a cap-weighted market value basis, the upper chart, termed the Reference Portfolio and on a fundamental accounting basis, the lower chart, has expanded steadily since the 1970s and now has become the dominant sector of the US equity market. By comparison, the Tech bubble was a fleeting aberration, now absent from the trends. In the same charts, updated to June 2007, found in their book The Fundamental Index, there was only a slight pullback in the share of the Financial sector in the Fundamental chart while the market value chart looked the same. Unfortunately, there are no numbers visible so it is hard to compare with today's data and I wish and hope that the folks at Research Affiliates where messrs Arnott et al work will do updates.

2) Financials have bounced back from 11.6% of US total market cap at the end of February 2009 to 16% in 2010, according to the proportions of holdings in Vanguard's Total Stock Market ETF VTI.

3) In Canada, one could almost say that the equity market consists of Financials and a few other bits and pieces - by market cap, Financials occupy 31% of the iShares TSX Composite ETF (XIC), while the Canadian RAFI Fundamental Index ETF of Claymore (CRQ), which contains 65 of the largest companies measured by a combination of sales, cash flow, dividends and book equity, has no less than a 47.4% weight in Financials. The folks who make the RAFI indices describe them as representing the companies' economic footprint. Is that really what the Canadian economy now consists of, and is it normal or healthy such that a change may happen sooner or later? The comparable market cap ETF to CRQ is iShares TSX 60 (XIU). Interestingly, it shows the market under-weighting Financials, especially insurance companies like Manulife and Sunlife, by some 13.4% (i.e. Financials are 34% of XIU) compared to CRQ.

4) The UK's FTSE All Share Index still has about 21% of its market cap weight in Financials as of the end of February 2010, judging by the db x-trackers ETF that tracks this index. Again, it is the single largest sector, though just barely ahead of oil and gas.

1 comment:

larry macdonald said...

Good analysis. Maybe the growth reflects the fact that the financial sector is an instrument of government policy to stablize the economy. Also, alot of the risk in the final sector is socialized while the profits are privatized.

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