Investors are bullish on the US financial sector, with 28% predicting it will be the best performing sector this year (more than any other sector) in a recent Morgan Stanley survey, despite the fact that banks and life insurance firms are already at the top of their historical range for price-to-book valuations and MS predicts only gradual return on equity (ROE) improvements this year.

Financial sector valuations tied to ROE

“Within Financials, Price/Book multiples are closely tied to the ROE performance of the business. A higher ROE equals a higher valuation and vice versa. Stocks where ROEs are improving thus become fertile ground for investment outperformance,” writes Morgan Stanley analyst Betsy Graseck.

ROE v multiple expansion 0314 Financial sector

Financial sector ROE has dragged over the last few years, facing low interest rates, increased capital requirements, and a weak recovery. Graseck argues that these factors will start to abate in 2014, but that financial ROE will only have limited improvement this year. Despite these headwinds, financial valuations are above their five-year median PE and approaching five-year highs for PB in most sectors.

Financial sector  valuation v 5yr 0314

Valuations a bit high, buy-side bullish

Since ROE is supposed to be linked to multiple expansion, financial sector valuations are already on the high side and ROE improvement is going to be muted, you might conclude that the financial sector will have a slow year, but it has the most support among buy-side analysts, according to the MS survey. It also found that 49% of buy-side analysts are overweight on US financials (compared to 35% last year and 30% in 2012), 35% are equal-weight (39% last year and 27% in 2012), and just 16% are underweight (26% last year and 43% in 2012).

Morgan Stanley analyst Adam Parker agrees, shifting his stance on the sector to Overweight after starting 2013 rating it as Underweight. He recommends an 18% exposure to financials, 170bp above the benchmark.

While the overall sentiment certainly fits with the rest of the market’s overall bullishness, part of the change in attitude that the survey captures may be lowering expectations.

“Investors have come to expect lower returns as the once popular 15%+ ROE goal now seems to be more routinely cited as 10%+. Along the way, investor valuation paradigms have shifted lower to reflect the likely reality of lower future returns,” writes Graseck, who says that dividends and buybacks have become a more important source of returns.