FINANCIALS BENEFIT FROM A STEEPER YIELD CURVE AFTER FED EASING -- HOMEBUILDERS ATTRACT NEW BUYING AND ARE DAY'S STRONGEST GROUP -- SECTOR ROTATION MODEL NOW FAVORS FINANCIALS
JANUARY BRINGS MONEY BACK INTO FINANCIALS... Although January was a bad month for the market, there were some sector rotations going on beneath the surface. To put things into perspective, Chart 1 plots two leaders (energy and technology) and two laggards (financial and consumer discretionary stocks) against the S&P 500 (flat line) during the second half of 2007. Those four groups reversed roles during January. Although all ended in the black for the month, January's two strongest groups (on a relative basis) were financials and consumer discretionary stocks (primarily homebuilders and retailers). By contrast, the two weakest groups were technology and energy. That rotation makes sense. Since financials and consumer discretionary stocks were the first to peak, it stands to reason that they would start to attract some money coming out of old leaders (like energy) that were starting to fall. Money coming out of former leaders needs to find a home somewhere else in the market. Apparently, money managers have been "bottom fishing" in the market's cheapest stocks, which include financials and housing.
Chart 1
FED EASING STEEPENS YIELD CURVE... One of the factors supporting financial stocks is the steepening of the yield curve resulting from recent aggressive Fed easings. Athough this sounds complicated, it's really pretty simple. The yield curve refers to the difference (or spread) between short-term rates (usually the 2-year yield) and long-term rates (usually the 10-year yield). Chart 3 plots the 2-year Treasury yield as the flat black line. The blue line plots the 10-Year Treasury Note yield (blue line) relative to the short-term yield. Plotted that way, you can see the relationship between the two (plotted as a ratio). During a period of economic weakess, the Fed lowers short-term rates aggressively. That pushes short-term rates much lower than long-term rates and results in a steepening yield curve (see 2001 to mid-2003). During an economic upswing, the Fed raises short-term rates. That causes short-term rates to rise faster than long-term rates and a flattening yield curve (like 2004 to 2006). The six Fed easings since August of last year have caused short-term rates to fall faster than long-term rates, producing a steeper yield curve. Although all yields are falling, shorter yields are falling faster than longer yields. While the Fed controls short-term rates, long-term rates are also influenced by inflationary expectations. The threat of rising inflation from those Fed easings (and a weaker dollar) also explains why bond yields are holding up better than short-term rates. Financial institutions (like banks) pay short-term rates to their investors and lend at long-term rates. Hence, they profit when the yield curve steepens.
Chart 2
BANKS CLEAR 50-DAY LINE ... Chart 3 carries three important pieces of information. First, it shows the PHLX Bank Index trading back over its 50-day average for the first time in four months (brokers are doing the same). Second is the mid-month upturn in the BKX/S&P relative strength ratio (below price bars). Third is the sharp drop in the three-month T-bill rate at mid-month (bottom line). That drop was the result of the aggressive Fed easing last week. That's when money started flowing back into financial stocks as the yield curve jumped (see arrows).
Chart 3
HOMEBUILDERS ARE DAY'S STRONGEST STOCKS... Since the Fed lowered short-term rates by 75 basis points last week, homebuilding stocks have been staging a comeback of sorts. Chart 4 shows the PHLX Housing index climbing over its 50-day average for the first time since last June. It's relative strength ratio (below chart) has risen to the highest level in four months. When was the last time you can remember a homebuilder being the strongest stock in the S&P 500? It happened today when Pulte Homes climbed 20% to reach a new four-month high (Chart 5). The stock broke through its 50-day line last week just after the Fed dropped rates by 75 basis points. Upside volume has been very impressive since then. So has the stock's rising relative strength ratio. [Three of the top five percentage gainers in the S&P 500 today were homebuilders]. Although it's much too soon to call for major bottoms in financials and homebuilders, this week's buying in both groups shows that the Fed's actions are having some effect. It also shows where money managers are starting to put some of their money.
Chart 4
Chart 5
IT'S THE FINANCIALS' TURN ... I've shown the Sector Rotation Model before to show which market sectors do better at various stages of the business cycle. Although it's not perfect, it has provided a useful roadmap to tell us where to look next for some market leadership. This diagram is one of the reasons that I started recommending consumer staples (including healthcare) and utilities a few months back when the market and economy started to weaken. Some of those groups have experienced new selling over the last month. That includes energy stocks which are usually one of the last groups to peak. The point I'm making today is that Financial stocks are next in line after Utilities in terms of attracting new monies at this point in a weakening cycle. That's because financials are among the first to react positively when the Fed finally starts to lower rates. That would seem to support recent signs that money managers are starting to rotate into historically cheap banks and brokers.
Chart 6
