Trader’s Narrative

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.

Today’s market notwithstanding, the financial sector has started to lead the general market once again.

Here is a chart of the Philadelphia Banking Index (BKX) alongside the S&P 500 Index (SPX):

The de-coupling started just recently but it is unmistakeable. Here is another way of looking at the relationship between the indices:

The change has just started and it is far too early to declare a trend change just yet. For that, we need to see the downtrend line broken to the upside by a continued surge in the financial sector.

But the important thing is that counter intuitively, a bull market doesn’t need the financial stocks’ leadership.

Bullish Percent
The spike low corresponds to late June, when the bullish percent for the banking sector dipped below 10% - actually going all the way to 5.62%. The last time we saw the bullish percent this close to zero was back in mid January 2008. And as far as I have data, never before!

Tectonic Shifts
This financial turmoil is unprecedented. For as far as the Philadelphia Banking Index has been trading, it hasn’t broken down this drastically. What we are seeing is tectonic shifts in the banking industry which will not only reverberate for some time to come, but it will produce a horizon drastically different from the one we knew just a month ago.

The financial stocks are not doing too well right now. I’m just telling you in case you’ve been hiding under a rock or have been floating in sensory deprivation tank for the last whee bit.

It seems everyone is looking at the poor financials and noting how weak they are relative to the market. The shibboleth is then trotted out that we need the financial stocks for a healthy bull market. I’m sure you’ve heard or read this multiple times.

I caught myself repeating it in my previous post (see above link). But rather than accept it at face value, lets put it to the test.

Does a bull market truly need the leadership or participation of the financial sector?

To begin, here is the chart of the Philadelphia Banking Index (BKX) compared to the S&P 500 Index (SPX):

Remember, this is a relative chart. When the financial sector is doing better than the general stock market, the line trends up, and when they are weaker than the general market, the line goes down. And while the ratio showed incredible volatility between 1998 - 2003, the BKX was relatively unchanged, simply treading water the whole time.

Now lets see how the market actually behaved during the times that the financial stocks were leading and during the times that they were weak:

The bull market didn’t start in 1995 but it certainly did intensify with a sharp upturn in its slope. While the S&P 500 continued to rally - with intermittent corrections - until 2000, the Philadelphia Banking Index (BKX) only kept up its leadership till early 1998.

From then to the S&P 500 market top (otherwise referred to as the “bubble top”) financial stocks actually performed weaker than the general market. It certainly didn’t faze the bull market though.

Bull or Bear, Banks Don’t Care
As the tone changed and a bear market took hold, the financial stocks re-awakened and took leadership once again. They actually performed better than the S&P 500 as the bear market raged on. In retrospect, they were a decent hiding place. You didn’t make much money on an absolute level but you didn’t lose money either. If you had borrowed a tactic from a hedge fund playbook, I suppose you could have made money going long financial and short the S&P 500.

Finally, as the bear market subsided and a new bull market was born, the financial sector lost its luster and started to underperform again. Little at first but more recently, at a torrid pace.

I know this is a short slice of market history but even from such cursory analysis it seems that there isn’t much stock in the common belief that financial stocks need to lead a rally. Nor that they need to perform better than the general market for us to enjoy a bull market. In fact, there is no real relationship that I can discern. If you see one, please edumacate me.

I believe there are conditions that precede bull markets - this just isn’t one of them.

Sacred cows make the best burgers and this one is of kobe proportions. If your blood-lust is not satiated, let the intellectual slaughter continue by checking out how cumulative breadth can be misleading.

Here’s an interesting chart comparing two slices of the US stock market:

In early April, around the time the stock market recovered from the March bottom, suddenly the Mid Caps (right axis) and the Large Caps (left axis) parted ways.

This is rather strange because they walked hand in hand for a very long time. I’m not sure why exactly. Even more puzzling, the S&P 400 Mid Capitalization Index (MID) also outperformed the S&P 600 Small Cap Index (SML) - not shown on chart.

Any ideas why the Mid Caps are hitting the sweet spot now?

The market does tend to go through drawn out cycles when the large caps and the small caps take turns leading.

Here is an updated chart of this relationship showing that maybe, just maybe, the small caps are about to regain the limelight:

And here is the same chart, this time comparing the Mid Caps to the Large Caps. No question here which is leading:

As the Mid Caps and Small Caps battle it out, one thing seems clear, the big cap stocks look like they are the losers going forward. If you want to take advantage of this you can switch out of SPY into an ETF like Rydex S&P Equal Weight (RSP) (if you’re feeling like a hedge fund, short SPY and then go long RSP). Or you could just buy small cap or mid cap ETFs:

• MidCap SPDRs (MDY)
• Vanguard Mid-Cap (VO)
• iShares S&P MidCap 400 (IJH)
• iShares Russell Midcap (IWR)