Financials No Longer Dictate The Direction of The Stock Market

I update the sector weightings inside the S&P 1500 each Saturday morning and it feels like just about every week I have subtracted a few basis points off the financials sector (XLF) ever since writing my very first article for Minyanville. Back then I shared that, according to my work and including the strange indicator unveiled there, this sector was dramatically over-owned, so much so that by itself it provided headwinds to the overall stock market’s performance. Despite plenty of (false) rallies and even more discussions since, the underlying shift has been quite simple: Financials have declined and inflicted significant mathematical damage to the index.

While the focus remains on what banks' customers are doing, I’d rather look at market share from a much more important customer for the stocks: Index investors and the trillions chasing them.

But a lot has changed since that day in May 2006. I was a little lonely back then, so let’s do it again with another strange prediction: As our financial problems have grown, I see something entirely different – that their headwinds on the rest of the market have decreased.

The sector’s weighting continues to melt, right now at 16.1% (I had to adjust it down another 30 basis points from when I started writing this article just two days ago). In my view these disasters may perversely prove at this point to be a fly in the ointment for bears on the overall stock market.

Say what? They simply hold fewer few votes for the election known as the closing print every day.

If I’m net short, I’m at least a little nervous about why the biggest problems in banking history announced for the biggest sector in the stock market haven’t taken the market down more than about (3%) year-to-date. If I’m one of many, many under-invested longs I’m a little nervous about the same thing as well.

I could be whistling past a few graveyards, and there are plenty, but I point that weighting out because if we accidentally find ourselves at break-even for the year all of the sudden or positive (that is still allowed, I’m told), won’t it be interesting if the burden of proof shifts from the bulls to the bears and their primary piece of evidence is missing?

What if financials no longer dictate the direction of the stock market?

Don’t look now, but as of this morning the sector just lost its #1 spot and is now in a dead heat with technology (XLK), and charging fast is energy (XLE).

Since I do not trade the overall market, I’ll leave others better equipped to answer the above question. I have stated repeatedly, however, that I am much less convinced than most that we “need” financials. For my firm, we’ve simply not owned them and been able to make money. Now, the stock market is slowly agreeing, cutting them from a massive over-weight to a big over-weight.
 

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Meanwhile, it seems like I add a few basis points to the updated weighting of the XLE each week. The sector which we have been writing just about every month as our firm held a triple, double, and now market weighting, is all the way up to 14.5% of the S&P 1500. That’s a different lens to look through for all the obvious problems higher energy prices give us – on the contrary, they’ve saved this market.

As I’ve always wondered, how many inflation problems do you have personally if after every debate about the CPI ex-food and energy, you simply invested in food and energy?

Looking through this lens, you wonder how much higher oil prices “hurt” the market when you see how much capital is now invested in the sector, which does not even include solar stocks (S&P classifies solar stocks as technology, but they are far more correlated to a barrel of crude than a barrel of free cereal at Google (GOOG) headquarters).

Nor does this weighting include a lot of energy-related stocks that live in the industrials (XLI) or materials (XLB) sectors. Add those together and you get a much different answer to the most-asked question today. Every other sector is begging for that kind of pricing power.

I think the problems for the bulls are quite clear and, this spring, perhaps became all too clear, and was when we started adding trading longs to our core longs. What is less clear is what happens when the worst news is no longer the lead story. With only $16 of every $100 now indexed to financials it will be just a little bit harder for its stocks' declines to do as much mathematical damage. Over one-third of their votes have disappeared in the past 12 months alone.

It is no accident that technology and energy (T&E) have been closing ground relentlessly on the financials in my Saturday morning derby. I have written several times, and held a tournament, about which stocks and sectors derive revenues from other currencies and T&E lead the pack.

It’s not a particularly close race: The “sweet sixteen” from that tourney are up +12% in less than two months since that was posted on an equally weighted average vs. +5% for the S&P 1500. Turns out financial problems (leading to weaker dollar) give birth to opportunities (those who don’t get paid with them). Could we slowly but surely see the same for an index increasingly paid with other currencies (sectors)?

K&C Trading Rule #11: When the inputs change, so should the outputs.