A Summertime Financials Sequel Coming Soon

Includes: XLF
by: Eric Parnell, CFA

All of the recent chatter has been focused on the debt ceiling debate. The good news is this is a situation that can be resolved once the folks in Washington decide to finally come together. The bad news is that the focus on the debt ceiling is obscuring a far more troubling development, which is the revival of more stress in the euro zone after only a few days of relief. And while the steady stream of rescue packages have assuaged investment markets to this point, the financials are indicating that stocks may have finally had enough. We saw this movie with the financials once before in the summer of 2007, and it appears we could be setting up for a blockbuster sequel in the summer of 2011.

The importance of financials to investment markets cannot be understated. If capital markets are not functioning properly and access to credit and funding markets is choked off, the economy begins to suffocate. This is the episode we saw play out during the financial crisis a few years ago. Thus, if the financials are under stress, it’s only a matter of time before it catches up with the broader market.

The performance of financials is highly correlated with that of the overall stock market. For example, since the market bottom following the bursting of the tech bubble in 2003, financials as measured by the Financial Select Sector SPDR (NYSEARCA:XLF) have had a positive correlation of more than +0.9 with the S&P 500 Index. When the market was rising from 2003 to 2007, financials led the charge. When stocks tumbled during 2007-09, financials fell first and hardest. And since 2009, financials and the broader market have shared the climb back up together. That is, until recently.

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So far in 2011, stocks and financials seem to have parted ways. After moving in lockstep through the middle of March, the broader market found the resolve to carry on higher. Not so for the financials, however, which continued to slide back down into the summer. Perhaps this is nothing more than a short-term dislocation. Then again, perhaps more is at work. But if nothing else, given the close past relationship between financials and the broader stock market, one of two outcomes is likely. Either financials rise to catch up with stocks, or stocks fall to meet back up with financials. But like any good summertime cliffhanger, perhaps it ends up being the shocking third outcome few saw coming: Financials fall off the cliff, dragging stocks down with them.

The pattern we’re seeing form in the summer of 2011 bears a striking resemblance to what we saw taking shape in the summer of 2007. After starting 2007 in lockstep through the middle of March, stocks and financials began to deviate heading into the summer. And by the end of July 2007, stocks and financials were at virtually the same exact place they find themselves at the end of July 2011. Stocks were up just under 3% year to date through the end of July then; they are up just over 3% year to date today. Financials, on the other hand, were down 8% year to date through the end of July then, and they are down 8% year to date today. Striking coincidence? Perhaps. But then again, there's more to it. Clearly, it’s worth taking a closer look.

We all know how things played out from the summer of 2007 on: Financials in the United States began crumbling under the weight of toxic assets tied to the U.S. real estate market. This led to a contagion that quickly spread to the global economy and financial system.

Do we have anything similar taking place in 2011? Yes, but like many sequels, the heart of the story has moved outside of the U.S. to exotic international locales throughout Europe. It is a story that takes us from Athens to Dublin, Lisbon to Madrid, Rome to Brussels, and Paris to Berlin. Unfortunately, it’s a story that could end badly with all of the money trying to flee to Gstaad and into gold. It is, of course, the ongoing European sovereign debt crisis. And in this story, we have countries buckling under the weight of too much debt that they may never be able to pay back.

Signals out of the euro zone over the last few days have been troubling. The latest financial rescue package announced late last week was supposed to buy the euro zone some additional time – possibly six months to a year -- to heal and for financial institutions across the region to further recapitalize. But after only a week, we’re already seeing things heading in the wrong direction.

The two important countries at the core of the crisis are Spain and Italy. If either one begins to fall apart, the resources in the euro zone may not be available to rescue them the way Greece, Ireland and Portugal have been supported to date. A measure of the market comfort level with the ability of Spain and Italy to meet their debt obligations is their respective 10-year government bond yields. The higher the number, the greater the implied investor doubt that these countries will be able to pay their debts. More specifically, a yield rising above 6% becomes particularly problematic in either of these countries being able to continue funding themselves.

After Spain had eclipsed the 6% level and Italy moved precariously close to it, the yields in both countries fell sharply on the news of the European Union rescue plan announced last Thursday. But in the days since, Spain’s has climbed back to within a hairsbreadth of 6% with Italy trailing not far behind. Needless to say, this does not bode well. Perhaps these yields will eventually back off, but it is a situation that bears a very close watch in the coming days. If it worsens, more trouble could lie ahead for stocks.

So why should we care if countries in Europe can’t pay their debts? Because many of the major banks across Europe hold a good deal of this debt on their books. If these countries default, these banks will have to sustain these losses, which has the potential to dry up their capital. Then there’s the second derivative instruments that these banks deal with such as credit default swaps that must be settled, which could also threaten the capital base of these institutions. And then there’s the unforeseen third derivative fall out effects that may not have been anticipated by policy makers and markets. And why should we care if the problem is focused in European banks? Because many of the largest American counterparts are deeply intertwined with these institutions across the Atlantic. Just like in 2007 when the American financial problem spread to Europe, in 2011 the European financial problem could just as quickly spread to America.

So while all eyes are on the debt ceiling debate, it may be worthwhile to click back over to the euro crisis, as this could be the real production making legendary headlines before it’s all said and done.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.