Trader’s Narrative

The spring rally began in early March with the financial sector taking leadership and rising from a death spiral. The Philadelphia Banking Index (BKX) rallied with such a ferocity that in about two months time it had more than doubled.

In fact, by early May 2009, the financial sector had gone up by an astronomical 135%! Meanwhile, the wider market index, the S&P 500, had only managed a 35% increase. On its own, that was very impressive rally but it pales in comparison to the banks.

The banking sector is now 13.35% of the S&P 500 - it reached a low of 8.57% on March 6th (to see more historical data and graphs check out: Historical Weight of Financial Sector.)

But while the S&P 500 went on slightly higher in June, the financial sector as measured by the Philadelphia Banking Index (BKX) started to lag. This was the first time in many months that it didn’t move in lockstep with the general market.

So if the Banking Index (BKX) has given up leadership, which sector is driving the market higher?

Currently the Semiconductors (SOX) is going strong with Information Technology being the largest sector of the S&P 500 at 18.3%. As well, Transportation and Energy sectors continue to have relative strength. The question is, is this a normal sector rotation or does the weakness in the important financial sector mean that the market has lost an important leadership sector and will weaken as a result?

One of the signs of the tech bubble was how Information Technology as a sector ballooned from less than 6% (in 1989) to 29.18% (in 1999) in relation to the S&P 500 capitalization. Turning that idea on its head, let’s take a look at the financial sector during the past few years as a ratio of the general market.

As a caveat, let me reiterate that bull and bear markets within the financial sector don’t correspond to the general market: Does a bull market need financial stocks leadership? While at first it may be counter-intuitive, the data backs up the conclusion as you can see from the link.

But nevertheless, following the weight of sectors within the total market capitalization can help us in getting oriented. So I looked at the Standard & Poor’s Financials sector which includes the following sub-sectors (and more):

• Banks
• Consumer Finance
• Diversified Financial Services
• Real Estate Investment Trusts
• Insurance Brokers
• Life & Health Insurance
• Multi-line Insurance
• Property & Casualty Insurance

Here is the annual weight of the financial sector and the banking sub-sector relative to the S&P 500 capitalization (the charts below are interactive so mouse over for details). I was surprised to see that the financial sector topped out in 2006 at a whopping 22.27% of the total value of the S&P 500 index. That’s almost 3 times what it was in 1990:

Zooming in, we can see the monthly weight of the financial sector as a percentage of the total S&P 500 index capitalization from the start of the most recent bear market:

At the extreme low, set in early March 2009 just as the rest of the market was making its recent low, the financial sector reached a critical level it hadn’t seen since 1990! Since then it has jumped to 12.6% as the financial sector has lead the recovery in the general stock market. While no one knows if this is the definitive bottom for the banks, we can say that the March lows were a major low where the sector was as unloved as it has been for the past 20 years.

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Here’s a novel way of looking at the Philadelphia Banking Index (BKX).

Turn it upside down!

Credit: Yes and Not Yes

And voila! the parabolic move is suddenly so much more recognizable. Keep in mind the parabolic move is obvious even when the chart is logarithmically scaled. Of course, when any market trends with more and more intensity, it approaches an eventual exhaustion point. We’ve seen this in every single bubble formation - no matter what the underlying security being traded: gold, bonds, stocks, tulips, etc.

The last time I mentioned this type of technical formation was last year when we looked at the price of crude oil. The price chart of oil had the unmistakable characteristic of a bubble, taking less and less time to increase more and more. It took one more month for the oil bubble to be pricked.

The chart above would suggest that the exhaustion point for the beleaguered US financial sector is near. No one knows if what we’re seeing is yet another short lived counter rally or if it is really the blow off. What is clear, however, is that the trend has very little time left to breathe (if it hasn’t given up its last gasp as of yet).

The Question
Here’s an interesting video which covers the question on everyone’s mind: is this rally the real deal? or another run-of-the-mill bear market rally? It also uses Fibonacci levels to provide some levels to watch for next week.

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While this bear is busy mauling everything in its path, there are some pockets of strength. One of them is right under our very noses: the Nasdaq composite index.

The individual charts of the Nasdaq composite and the S&P 500 Index, each show a crushing bear market. But the relative chart shows that out of the two, the Nasdaq is surprisingly strong.

Going as far back as 2006, Nasdaq’s relative strength has been putting in higher highs and higher lows.

But before we can get excited, the ratio of the Nasdaq to the S&P 500 ratio has to break 1.90 - that’s because since 2004, it has been in a holding pattern below that level. The last time it broke through was in early 1999, and you know the rest of that story.

Financial Sector
Of course, the sector that has everyone’s attention is the financials: banking, investment houses and brokerages. Although technically, a bull market doesn’t need the financial stocks leadership, this market has been primarily driven by the bank stocks because they have been the protagonists in this tragedy (or farce, depending on your point of view).

Today, the financials make up only about 10% of the S&P 500 index. So in a twisted sense, this sector has fallen so much that from here on in, it has much less weight to influence the general index. And that might be a good thing because while it may take decades for the US banks to come out from under the shadow of government intervention into some semblance of normalcy, the rest of the market can push forward.

The financial sector has been beaten to a pulp during this latest bear market. Every time it gets extremely oversold, it manages a feeble bounce only to dive down headfirst once again.

During the past 12 months or so the bullish percent index has jolted from one extreme to the other. According to the bullish percent index for the sector, it looks like we are setting up for one of these bounces:

If we zoom into the chart we can see things a little bit better:

And here is a corresponding chart of the Philadelphia Banking Index (BKX):

This bear market has been unusual because the financial sector has been one of the key players. In previous bear markets the banking sector has actually outperformed the general market. But obviously not only have they failed to keep up with the market lately, they have been the reason why it is dropping like a rock.