XLF: Fairly Valued And Our Reading Of The Market

XLF: Fairly Valued And Our Reading Of The Market

zbruch/iStock via Getty Images Thesis and Background

We use the following market sector dashboard to put our finger on the pulse of the market and its major sectors. Especially, the simple YS (yield spread, defined as the TTM dividend yield minus the 10-year treasury rates) is the first thing we look at. They give us a 30,000 feet view of where to look further – which sector, growth stocks, value stocks, bonds, or precious metals, et al. We will detail the meaning of each entry in the next section, and we update the dashboard monthly. Feel free to download or export the google-sheet via the following link too: Market Sector Dashboard .

A few overall impressions on the market and the Select Financial Sector SPDR ETF ( XLF ) this month: The yield spread between XLF and risk-free rates is almost exactly at the historical mean now. With a YS Z-score near 0.0, XLF (and the financial sector) is at a fair valuation relative to its historical valuations.

The dashboard also shows that XLF is now also fairly valued compared with other sectors. The small-cap, energy, health sector are the most undervalued sectors now.

Surprisingly, the overall market (represented by a simple average of the sectors in the dashboard) is also fairly valued relative to the treasury risk (the Z-score is exactly 0.0%). For us, this signals that equity, especially high-quality stocks with a reasonable valuation, are more favorable than bonds.

Lastly, the results and dashboard apply to other similar funds too, such as the Vanguard Financials Index Fund ETF Shares ( VFH ) and iShares U.S. Financials ETF ( IYF ), because these funds are quite similar and their valuation closely correlated.

With the above overall discussion, we now move on to the specifics of the dashboard and XLF. Author The dashboard explained

Note: if you are familiar with our Market Sector Dashboard already, you can skip this section. It describes the mechanics of the dashboard. The yield spread Z-score. It gauges the dividend yield of a given sector relative to the 10-year treasury rates. How the yield spread calculated will be detailed in the next section. A larger Z-score suggests larger undervaluation compared to the historical record and treasury rates. And vice versa.

A Z-score that is closer to 1 means the yield spread is near the thickest level of the historical spectrum and is color-coded by bright green. And vice versa.

The yield spread Z-score. Similar to the yield spread Z-score, it gauges the dividend yield of a given sector relative to its own historical record. A larger Z-score (greener) suggests a larger undervaluation compared to its own historical record. And vice versa.

Yield spread and yield spread Z-score

For bond-like equities fund XLF, an effective way to evaluate their valuation with interest rates adjusted is to calculate the yield spread. Details of the calculation and application of the yield spread have been provided in our earlier article . The yield spread is an indicator we first check before we make investment decisions. We’ve fortunately had very good success with this indicator because of: Its simplicity – it only relies on the simplest and reliable data points (treasury rates and dividends). In investing, we always prefer a simpler method that relies on fewer and unambiguous data points rather than a more complicated method that depends on more ambiguous data points.

Its timeless intuition – no matter how times change, the risk-free rate serves as the gravity on all asset valuations and consequently, the spread ALWAYS provides a measurement of the risk premium investors are paying relative to risk-free rates. A large spread provides a higher margin of safety and vice versa.

With this background, you will see below that when adjusted for interest rates, XLF is at a fair valuation compared with its own history valuations.

The following chart shows the yield spread between XLF and the 10-year treasury. The dividend yield is calculated based on the TTM dividends. As can be seen, the spread is bounded and tractable most of the time. The spread has been in the range between about -1.5% and 0.5% the majority of the time during the past decade. Such a tractable YS suggests that when the spread is near or above 0.5%, XLF is significantly undervalued relative to the 10-year Treasury bond (i.e., I would sell treasury bond and buy XLF). In another word, sellers of XLF are willing to sell it (essentially an equity bond with […]

source XLF: Fairly Valued And Our Reading Of The Market

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