There’s something brewing in the financial sector that could be worrisome to stock-market investors, especially those who shiver recalling events that led to the 2008-09 financial crisis.
And don’t forget about the great recession predictor, known as an inverted yield curve, that has also flashed a warning signal.
The SPDR Financial Select Sector exchange-traded fund XLF, -2.76% tumbled 2.8% Friday, with 64 of its 68 equity components losing ground. The financial ETF (XLF) has lost 4.9% this week, amid a multisession losing streak, as the Federal Reserve’s downbeat assessment of the economic outlook sent longer-term Treasury yields to 15-month lows. See Bond Report.
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The financial sector is viewed by many on Wall Street as a leading indicator for the broader market, given that it is such a big part of the S&P 500 SPX, -1.90% and of investor sentiment. Financials carried a 13.3% weighting in the S&P 500 as of the end of February, the third highest of the 11 S&P 500 sectors, and without a healthy banking industry, companies would have a hard time borrowing to invest in future growth.
Although the XLF had by some measure entered a bull market before its current losing streak, as it closed Monday 20.6% above its 2-year closing low of $22.31 hit on Dec. 24, 2018, by other measures it remained in a long-term downtrend.
The XLF has failed to get above the highs seen in November, which was when the markets paused just before the broad December plunge, while the S&P 500 index broke out to early-October highs, closing Thursday within a few percentage points of its record close. The Dow Theory of market analysis, which has remained relevant with market technicians for a century, defines a downtrend as a chart pattern in which ease successive rally peak closes lower than the previous high, while each successive trough is lower than the previous low.
By that definition, the XLF has been in a downtrend for the past 14 months, as the successive rally peak in September was below its January high. Some technicians would call that a bearish divergence relative to the broader market, as the S&P 500 reached a record high in September. Read more about bearish divergences.
Frank Cappelleri, executive director and technical analyst at Instinet LLC, pointed out in a recent note to clients that since 2010, the XLF and the S&P 500 have not diverged from each other for very long.
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Before that, however, in the months leading up to the financial crisis, there was a similar bearish divergence.
If that’s not enough to trigger some jitters, then maybe the following chart will. When charted relative to the S&P 500, the XLF has been trending lower for a little over a year. This week, it broke below the December trough to hit the lowest levels seen since October 2016.
The XLF’s current relative performance hasn’t exactly repeated what it did before the S&P 500’s pre-crisis bull market ended in October 2007, but it has certainly rhymed.
“If the financials continue to falter, they probably won’t do it in isolation,” Cappelleri told MarketWatch. “If that [divergence] continues, eventually the S&P 500 will have to take notice more than it has as of this point.”
There is some fundamental backing to the negative technical outlook. The year-over-year aggregate earnings-per-share growth of 7.99% the financial sector posted in the fourth quarter was the lowest in five quarters, according to FactSet data. And for the first quarter, the EPS outlook swung to a decline of 1.7% from an increase of 3.1% late last year.
That’s not all. On Friday, the yield on the 10-year Treasury note TMUBMUSD10Y, -3.66% tumbled as much as 12 basis points, or 0.12 percentage points, to an intraday low of 2.418%, the lowest yield seen since December 2017.
Banks tend to not like lower longer-term yields, because it usually means they make less money when they fund longer-term assets, such as loans, with shorter-term liabilities.
They faced a similar scenario in 2007, when the 10-year yield broke below a multiyear uptrend, just before the S&P 500 topped out.
What makes the 10-year yield decline even more worrisome, is that it has now fallen below the 3-month T-bill rate, a development referred to as an inverted yield curve.
“While the yield curve is positively sloped, banks typically buy government bonds to take advantage of that slope,” Brian Reynolds, analyst and asset class strategist at Canaccord Genuity wrote in a recent research note. “When the curve inverts, the profits from this ‘carry trade’ disappear.”
The last time the 10-year Treasury yield fell below the 3-month T-bill rate was 2007. As MarketWatch’s Sunny Oh pointed out, inversions of that portion of the yield curve have preceded every U.S. recession going back to 1955, with only one false reading.
Up until Thursday, equity investors had cheered the Fed’s new dovish outlook. But given the financials’ recent nominal and relative weakness, and the inverted yield curve, perhaps the Dow Jones Industrial Average’s DJIA, -1.77% 460-point plunge on Friday and the S&P 500’s 1.9% tumble suggests investor are taking the financial sector’s relative weakness, and the Treasury market’s warning, to heart. See Market Snapshot.