Financials are the pillars of most major economies. The finance sector is also the key barometer of equity markets.A strong and sustained growth in equity prices is unlikely without the participation of the financials. This is especially true in developed markets where credit plays an important role in the economy.

UK-based Fund manager Sanjeev Shah of Fidelity Special Situations Fund believes equity markets are in the early stages of a bull market. From an article in Trustnet:

The manager believes financials will help to sustain the rally in the short-term, although in the long-run he points to more sustainable themes.

“I think we are in the early stages of a new bull market in equities, and in the short-term I believe financials have the opportunity to continue to provide leadership,” he said.

“However over the longer term it will be themes such as the emerging market consumer, the digital economy and internet which could provide leadership. I believe the commodity bull market is over.”

The manager thinks that fears surrounding financials prior to the crash of 2008 were just; however he adds that times have changed and the unloved sector will continue to strengthen.

“As a result of the financial and eurozone crisis, there has been a lot of concern regarding financials. This was justified given high levels of leverage and the need to write down assets,” he said.

“This led to financials becoming extremely disliked by investors and very cheap in a historical context. Crisis brings opportunity and there will be winners and losers in the new environment. HSBC is a potential winner given its strong capital and funding position.”

A quick check of European bank stocks trading on the US exchanges shows that financials have indeed recovered and most are up by double-digit percentage this year.

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Unlike their US peers, European banks have not yet built a solid capital position and are still in the process of writing off bad assets from their books. However compared to last year most of these banks are showing signs of improvement which is reflected the run in their stock profits. For example, ING Group(ING) has been getting rid of non-core business units in many countries to raise capital. In the U.S. it sold the ING Direct unit to Capital One Financial (COF) last year and in Scotiabank(BNS) acquired its ING Direct Canada unit.

It should be noted that some of the sharp increases in stock prices shown in the chart above are misleading since these stocks jumped from a very base. Llyods Bank (LYG) closed at $3.13 on Friday which is nowhere near where it used to trade before the global financial crisis. Generally stocks under $10 are highly volatile and can easily be moved around even with light volumes.The same can be said of some of the other banks shown as well. In addition, many of these banks currently pay much reduced dividends than before the crisis and some banks such as ING have still not reinstated their dividend payments which were suspended before. Hence from an investment perspective, it is not clear if the recovery in financials is indicative of a start of a bull market in Europe.

Disclosure: Long ING, SAN, BBVA, LYG

This time of the year asset management firms and others usually publish their top stock ideas for the following year. I found the following list from Canada’s RBC Dominion Securities interesting:

Source: RBC’s 30 top stock picks for 2013, The Globe and Mail

The above list does not include stocks from Asia, Latin America, Africa and the Middle East. These stocks have the potential to outperform the market according to RBC’s analysts. On the selection criteria  used, the article noted:

The bank culled the names for its best performers from among the 1,500 companies its analysts cover in Canada, the U.S., the UK and Europe. The analysts were told to offer their “best money-making ideas in absolute terms using a risk-adjusted approach.” The only restriction was that they had to pick larger-sized companies with market capitalization of at least $2-billion and a minimum of $20-million in daily trading value, stocks that would be suitable for a global institutional investor.

I am not yet convinced of investments in U.S. stocks based on the housing market recovery theme. Though most of the homebuilders and related companies have had a nice run this year, the real estate market does not seem to have bottomed out  according to my non-scientific observation.

Disclosure: Long PNC, SWDBY, TD

One way to gain exposure to growing economies outside of the U.S. is to simply invest in companies that generate a larger portion of their revenue from those economies. The advantage with this strategy is information about these firms is much easier to find and investors may already know most of these firms and their products. For example, many of the products of Johnson & Johnson (JNJ) and Procter and Gamble  (PG) are sold in the country and investors may buy those products on a weekly if not more frequent basis. These companies sell some of the same products in other countries sometimes under different brand names.

Another important benefit of investing in these companies is that they are able to have stronger earnings as the sales in foreign economies helps offset lower sales in the domestic market. Investors looking to add U.S. multinationals with rising revenues from foreign countries can consider the firms shown in the chart below:

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Source:  SCALED TO SERVE: THE ROLE OF COMMERCIAL BANKS IN THE U.S. ECONOMY, July 2012, The Clearing House

Demand for Caterpillar’s (CAT) products is high in emerging markets such as China due to high infrastructure development there. Kraft’s (KFT) purchase of British confectioner Cadbury in 2010 gives it more reach in fast-growing emerging markets. Tech giant IBM’s (IBM) earnings has remained strong in recent years due to the increase in outsourcing of services by companies and government agencies to reduce costs.

Disclosure: No Positions