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Is the Market Overvalued? A Look at the Financial Sector

With the TSX showing an impressive one-year return of 18%, a five-year return of 26%, and trading at all-time highs, investors should be feeling nervous. Are valuations getting ahead of themselves or is there room to go higher?

I prefer to answer this question by looking into the different segments of the market and making a case-by-case conclusion and hopefully finding the areas where we can find the most value. Let’s now take a look at the financials sector and delve a little deeper.

The financial index has a one-year return of 27% and a five-year return of 63%. Low interest rates have given the bank a hard time, but they have made up for that by stepping up their wealth management businesses and by expanding internationally.

We certainly have to compare these returns against economic fundamentals and market valuations to formulate an opinion on whether the market is overvalued or not. From a macroeconomic perspective, the financial sector is looking good as rates are on the rise, and this will benefit them through higher net interest margins. Furthermore, the aging population is a positive for financials, as they increasingly have demand to manage Baby Boomers’ money.

Valuations in the sector look fair given the position they are in today.

Canadian Imperial Bank of Commerce (TSX:CM)(NYSE:CM) and Royal Bank of Canada (TSX:RY)(NYSE:RY) both beat expectations in their latest quarters, and both raised their dividends in light of the positive results and outlooks. And while the stocks have both done really well in the one-year period and the five-year period, valuations look good given the upward bias of earnings. For example, CIBC has a one-year return of 28% and a five-year return of 56% and is trading at a P/E of 11.5 times. Royal Bank has a one-year return of 38% and a five-year return of 72% and is trading at a P/E of 13.4 times. Both have attractive dividend yields.

On to insurance companies.

Manulife Financial Corp. (TSX:MFC)(NYSE:MFC) and Sun Life Financial Inc. (TSX:SLF)(NYSE:SLF) both reported better than expected results in their latest quarters, which, as it does for the banks, supports the valuation. They also instituted dividend increases. Manulife trades at a P/E of 17 times, and Sun Life trades at a P/E of 12 times.

Financials are poised to continue to be winners in this environment of rising interest rates. These companies are already benefiting from this dynamic, but it is not too late for investors to get into these companies and see their portfolios benefit as well.

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Fool contributor Karen Thomas has no position in any stocks mentioned.

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