Banks, Small Caps and P2P

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The stock market’s 109 trading-day run without a 1% decline was finally broken last Tuesday.

The drop came following doubts about the Trump administration’s ability to pass healthcare reform, which prompted second thoughts about the ‘’Trump trade” among  investors.

However, with inflation at its highest point since 2012 and wages rising, fundamentals look solid. As such, this recovery still has legs and the decline could be a classic ‘’buy-the-dip’’ opportunity for investors.

Here are three assets investors should add to their portfolios for the upcoming quarter to profit from this trend.

#1 US Banks

From the election until the end of 2016, US banks (as a group) rose 22%. However, their recent drop puts them in negative territory for 2017.

But with the Fed on course to raise rates at least twice more this year, banks will likely surge due to their positive correlation to higher rates.

So this pullback is a buying opportunity… especially given that banks are still undervalued relative to the S&P 500.

Source: Bloomberg

David Kostin, chief US equity strategist at Goldman Sachs, recently recommended that clients be overweight banks. Kostin cited banks’ positive correlation to rising rates and inflation as the reason for owning them.

Investors may want to focus on institutions that have the most to gain from rising rates… like Bank of America. For every 1% increase in interest rates, Bank of America’s net interest income will increase by $3.4 billion per annum.

Credit Suisse is also very bullish on banks given the recent pullback. Lori Calvasina, chief US equity strategist for the firm said Credit Suisse’s highest conviction trade is financials.

#2 US Small Caps

Small caps rose 18% from the election until the end of 2016. However, just like banks, they are in the red for 2017. Also like the banks, the reasons for owning them are obvious.

Since 1979, small caps have outperformed large stocks by an annualized 2% during periods of rising rates. As the table below shows, small caps do exceptionally well when rates are rising.

Source: Perritt Capital Management

Around 80% of revenue from the companies that make up the S&P 600 SmallCap Index comes from inside the US. So, investing in small caps is essentially a bet on domestic growth.

Since 1986, small caps have been up 100% of the time when GDP growth was in the 2%–3% range. In 2016, value small caps outperformed their growth counterparts by 65%.

Credit Suisse and BNY Mellon have both recommended investors be overweight small caps given the recent pullback.

But before you put your money in the sector, be aware that not all small caps are created equal.

Investors will likely benefit most from small caps classed as value stocks (like financials and utilities) rather than growth stocks (like tech and health care).

#3 Peer-To-Peer Lending

Moving into fixed income, a new asset class that investors should consider is Peer-to-Peer (P2P) Lending. The P2P sector has grown rapidly in recent years and is a great source of fixed income. P2P investors are currently averaging 7% returns on 36-month loans.

Even those who took the most conservative approach saw returns of 5%.

What started as peer-to-peer lending has grown into a marketplace. The likes of JP Morgan and Citibank now account for over 65% of new capital. Goldman Sachs recently launched its own lending platform named Marcus, making it the first major bank to do so.

The sector is set to benefit from rising growth and inflation, so now is a good time to invest in it. As the economy improves, more borrowers will apply for loans. As investors’ appetite for risk increases, they will seek higher returns—which they can get through P2P.

Investors shouldn’t be concerned about rising interest rates either. As the industry has matured, lending standards have improved immeasurably and defaults rates have been steadily declining.

Source: GarretGalland

Of course, P2P lending comes with its own set of cautions. As P2P investing really only started to gain momentum in 2009, the platforms are largely untested in a serious and sustained economic downturn (with rising unemployment and soaring delinquency rates).

Given this and the fact that P2P loans are unsecured, you must be fully aware of how to enter this market and steer your way through it.

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