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5 Defensive Financial Stocks From KBW

NEW YORK ( TheStreet) -- Bank stocks have been pretty hot but investors might want to consider building defensive positions, since U.S. employment growth may not be enough to push the financial sector higher over the short term.

The KBW Bank Index (I:BKX) was up 12% year-to-date through Friday's close at 57.52, outperforming the S&P 500 (SPX.X), which was up 9% through Friday's close at 1,560.70. During 2012, the KBW Bank Index rose 30%, while the S&P 500 was up 13%.

"Financial stock performance has been closely tied to the bond market, with the correlation between the long bond yield and the top 40 financial stocks greater than 0.6 year-to-date," KBW analyst Frederick Cannon said in a report Sunday. The market yield on 10-Year U.S. Treasury bonds was 2.01% on Friday, increasing from 1.78% at the end of last year.

There have been some very encouraging economic reports lately, underscoring the continued recovery of the housing market, and improving employment growth numbers. The Labor Department on March 8 said the U.S. economy added 236,000 nonfarm jobs in February and the unemployment rate improved to 7.7% from 7.9% the previous month.

In another encouraging sign for employment growth, the Federal Reserve on Friday said the U.S. industrial capacity utilization rate rose to 79.6% in February, the highest level since March 2008. The February reading rose from 79.2% in January.

The prospect of industrial capacity utilization moving to levels not seen since before the worst of the credit crisis is a very positive development, as rising demand may finally push some skittish employers to increase their hiring. This is incredibly important to banks and their investors, who need a significant widening of the yield curve to propel profits, since so much of banks' earnings improvement over the past two years has come from the release of loan loss reserves, as credit quality has improved.

Most banks continue to see their net interest margins narrow, because the Federal Reserve has kept the short-term federal funds rate in a range of zero to 0.25% since late 2008, and the central bank continues to make monthly purchases of $85 billion in long-term securities, in an effort to hold long-term rates down.

In its statements this year, the Federal Open Market Committee has said the "highly accommodative" monetary policy is likely to continue at least until the unemployment rate improves to 6.5%. Members of the committee have hinted the Fed still might not turn off the money spigot when that threshold is reached.

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