One of the things we do on a regular basis is take a step back and look at which sectors are outperforming and which sectors are underperforming. This helps give us a good idea not only of where we are in the business cycle, but also of which stocks may see the most growth in the coming weeks and months.
Currently, we have our eye on the financial sector — and the Financial SPDR (XLF) — for a few reasons.
Sector Rotation
First, as you can see in the chart below, financials typically lead the way higher in the early stages of a market rebound.
Fig. 1: Sector Rotation during the Business Cycle
Now, we certainly are not at the beginning of the business cycle, nor are we in the early stages of a bull market (after all, the S&P 500 bottomed out more than six years ago). However, anytime you see financials doing well, you can be relatively confident — based on market cycles past — that the stock market is not on the verge of rolling over and starting a new bearish downtrend.
To gauge the current strength of financials, we like to keep an eye on the Financial SPDR. When the XLF is making higher highs and higher lows, we know there is some bullish sentiment on Wall Street. When XLF is making lower highs and lower lows, we know traders are shifting assets into more conservative stocks.
As you can see in Fig. 2, XLF has been consolidating along with the rest of the market but is poised to break higher if current support can hold.
Fig. 2 — Daily Chart of the Financial Select Sector SPDR Fund (XLF)
If this bullish break happens, it will tell us we are most likely in for more bullishness across the board in the stock market this summer because financials are also going to be a good barometer for market sentiment … based on the other two reasons we have our eye on the financial sector.
Yield Curve and Net Interest Margin
Financials are sensitive to changes in the Treasury yield curve — especially the middle part of the curve — because it impacts their net interest margin. Net interest margin is the difference between what a financial institution, like a bank, pays to borrow money and what it receives by lending money. For example, if a bank can pay depositors 1% on their savings and checking accounts and then turn around and charge its borrowers 4% for their loans, the bank has a net interest margin of 3% (4% – 1% = 3%).
You can track whether net interest margin levels are increasing or decreasing by measuring the difference between the yield on 2-year Treasuries and the yield on 10-year Treasuries.
Looking at Fig. 3, you can see the difference between the 2-year Treasury and the 10-year Treasury on June 1 was 1.55% (2.19% – 0.64% = 1.55%), while on Thursday, the difference had climbed to 1.7 (2.42% – 0.72% = 1.7%).
Fig. 3: Treasury Yield Curve (Source: Treasury.gov)
This is a trend that has been going on for a few weeks now, as traders have been preparing for the Federal Open Market Committee to raise interest rates.
The fact that we are seeing the FOMC gearing up to raise rates while XLF is not dropping is a good sign. It tells us that the benefits the financial stocks should reap from a wider net interest margin are trumping potential concerns about an interest-rate-hike-induced market pullback.
Greek Contagion
Lastly, with all of the hullabaloo in Greece and concerns over whether the country is going to default on its debt, financial stocks have remained quite resilient. This is a great sign seeing as how financials are probably the one sector with the most exposure to a potential Greek default.
Financial institutions hold a lot of Greek debt — along with Spanish and Italian debt — which could become increasingly volatile if Greece defaults and investors start worrying about a default contagion in Europe. If this debt dramatically loses value, it will put pressure on the financials’ balance sheets.
Financial institutions also are counterparties to a variety of credit default swaps (CDSes) and other financial instruments that could be triggered if Greece defaults.
Seeing financials remain steady in the face of these potential risks tells us that investors don’t think the chances of a Greek default and contagion are too high right now. If they did, they would be moving out of financials at a much faster clip.
The Bottom Line
If XLF can hold at support and start moving higher — perhaps even breaking above resistance — we will be able to confirm that the sentiment on Wall Street is quite bullish.
Conversely, if XLF breaks below support, we will know that sentiment has taken a bearish turn for the worse.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.
You can learn more about identifying price patterns — like a bearish continuation diamonds — and using them to project how far you think a stock is going to move in their Advanced Technical Analysis Program.
