FINANCIALS AND BANKS ACHIEVE BULLISH BREAKOUTS TO LEAD MARKET HIGHER -- A STEEPER YIELD CURVE MAY EXPLAIN RECENT ROTATION INTO FINANCIAL STOCKS
STEEPER YIELD CURVE SUPPORTS STRONG FINANCIAL STOCKS...A lot of positive group rotations have taken place in the stock market over the past two months.We've seen new money moving into domestic small caps stocks, as well as economically-sensitive transports. We've also seen cheaper value stocks gaining ground on growth stocks. The most notable rotation has been into financial stocks which have gone from market laggards to leaders over those two months. There may be one common thread tying all of those rotations together. And that is a steeper yield curve caused mainly by rising Treasury bond yields.
The daily bars in the lower part of Chart 1 show the Financial Sector SPDR (XLF) rising above its July/September peaks to reach the highest level since early 2018. That represents a bullish breakout. The change in relative performance is shown by the XLF/SPX ratio in the middle box. That ratio bottomed during August and is now challenging its early June peak. An upside breakout appears to be taking place there as well. Financial stocks are influenced by the direction of bond yields and the yield curve. Rising bond yields are beneficial, especially when accompanied by a steeper yield curve. And that's just what we're seeing in the upper box in Chart 1.
The green area in the upper box plots the spread (or yield curve) between the 10- and 2-year Treasury yields. Falling bond yields from June to August flattened the yield curve and caused financial stocks to weaken. The red area during August showed the 10-year yield falling below the 2-year which caused that yield curve to briefly invert and raised fears of an economic slowdown. The upper box, however, shows that version of the yield curve bottoming in late August and rallying sharply since then. That was caused mainly by a rising 10-year yield. Notice the close correlation between the rising green area and the XLF/SPX relative strength ratio just below. And both coinciding with a major upturn in financial stocks. The steeper yield curve over the last two months may account for a more optimistic view on the U.S. economy and the stock market. And may also explain the recent strong performance by small caps and transportation stocks as well as other groups tied more closely to the U.S. economy.
BANK STOCKS ALSO BENEFIT FROM STEEPER CURVE...Banks are the biggest part of the Financial XLF (43%) and have been the main force behind the recent rise in that sector. The daily bars in Chart 2 show the KBW Bank Index rising above its previous highs to reach the highest level in a year. Banks are the main beneficiaries of a steeper yield curve which means that longer bond yields are rising faster than shorter yields. Rising bond yields allow banks to charge more for loans than they pay depositors.
10 YEAR -3 MONTH YIELD CURVE NO LONGER INVERTED...The red area at the bottom of Chart 2 shows an inversion of the yield curve when the 10-Year Treasury yield fell below the 3-month yield during May and continued to drop into August; and was interpreted as a recessionary warning. The spread bottomed during August, however, and has now risen back over the zero line into the green area. That means that the 10-year yield is now higher than the 3-month yield for the first time in five months. Which means that version of the yield curve is no longer inverted. The chart also shows the upturn in bank stocks coinciding with the upturn in the yield curve during September and October and scoring a bullish breakout this week. The fact that both versions of the yield curve are no longer inverted (thanks to rising bond yields) may also reflect a more optimistic mood on the economy and stock market. And may explain the recent buying of stocks more closely tied to a stronger economy. Like transportation stocks.
TRANSPORTS NEAR UPSIDE BREAKOUT WHILE UTILITIES WEAKEN...Wednesday's message showed the recent upturn in transportation stocks, and suggested that an upside breakout would send an even stronger signal for them and the rest of the market. That may not be far away. Chart 3 shows the Dow Transports ending the week right up against their July/September highs. An upside breakout by those economically-sensitive stocks would be another vote of confidence in the stock market and the economy. Wednesday's message showed the transports rallying much faster than the Dow Industrials over the last two months. They're also gaining on the Dow Utilities. While transports were one of today's strongest groups, utilities were one of the weakest.
The transportation/utilities ratio in the upper box had been falling for most of the year as investors favored bond proxies like utilities in a climate of falling bond yields. It has turned higher, however, and appears to be breaking the falling trendline starting in April. That would be consistent with a climate of rising bond yields (and falling bond prices) as investors rotate away from dividend-paying defensive stocks into stocks that should do better in a stronger economy. Like airlines, railroads, and truckers.
TECH SPDR HITS NEW RECORD -- SO DO SEMICONDUCTOR ISHARES...Major stock indexes had a strong day and are very close to setting new records. Eight sectors closed higher led by technology, materials, energy, communications, industrials, and financials. The three weakest were real estate, utilities, and staples which ended in the red. In other words, investors bought economically-sensitive stocks and sold defensive ones. One of the sectors hit a new record. The lower box in Chart 4 shows the Technology SPDR (XLK) closing above its July peak in record territory. It was led higher by semiconductors which also reached a new record. The upper box in Chart 4 shows the PHLX Semiconductor iShares (SOXX) also clearing their recent highs.
S&P 500 CLOSES JUST SHY OF A NEW RECORD...Chart 5 shows the S&P 500 gaining 12 points (+.40%) today and closing above its September intra-day high at 3021. But it ended just shy of its July intra-day high at 3027. An upside breakout, however, seems more than likely. In addition to positive trends we've seen over the past couple of months (including higher bond yields), seasonal trends are also turning more friendly. Having survived the dangerous month of October, the calendar turns more friendly during November and December. The Dow and Nasdaq had an even stronger day and are also nearing their old highs. The Nasdaq saw its highest close in three months. Small stocks also saw bigger gains today. All of which increases the odds for a strong end to the year.
