Why You Should Not Bank On The Stupefying Strength In Financial ETFs

by: Gary Gordon

Chartists often like to view sector performance relative to the S&P 500 via a price ratio. For instance, if you are interested in basic materials stock momentum, you might investigate XLB:SPY over a particular period of time.

In comparing price ratios for each of the 9 largest sector ETFs on 3/20/2012, only two can be said to be gaining in relative strength: technology and financials. Historically, when these two segments are leading the pack, bull markets tend to be in their earliest stages.

Great news, right? Well… not exactly.

Since the 2008 meltdown, leadership from the financial stock arena often marked the beginning of painful corrections. For instance, financials rallied to the forefront of the sector leader-board in May of 2009; shortly thereafter, financials plummeted and the rest of the market struggled with a 10% summertime sell-off.

The pattern has actually repeated itself each successive year. Financial stocks were the darlings of 2010 up through April. Then they sank, leading the way for an economic soft patch and a 6-month period of stock market malaise. And then we have 2011. The SPDR Sector Select Financials Fund (NYSEARCA:XLF) peaked near 17.0 in March of 2011, before succumbing to a brutal drawdown of -35%. The rest of the 2011 stock market followed XLF down the rabbit hole with top-to-bottom declines ranging from 19%-25%.

I’d really like to believe that this is time is different. Unfortunately, I feel there’s something to this disturbing pattern.

For one thing, even though the large-cap U.S. benchmarks continue breaking out to multi-year highs, the number of new highs and lows over the past few months on the NYSE has been somewhat anemic. One would be more impressed by the S&P 500’s “accomplishments” if we were witnessing an increasing number of stocks logging new highs. Unfortunately, market breadth is weak.

Secondly, the fast start to the year for all risk assets has been petering out. Emerging market stocks, European stocks, U.S. smaller cap stocks, dividend stocks, energy, materials, industrials, health care – each seems less willing to “go along” with Dow 13000 and the S&P 500’s 1400. Indeed, it may be the false prophet of U.S. financials that is actually carrying the popular indices, with a little help from Apple-mania.

This is not a bearish call… I let stop-limit loss orders and VIX volatility hedges protect against downside risk. But this is recognition of a reality that a few key sectors and a few key indexes may not be able to ignore the drag of other risk assets for much longer. Something may have to give.

Financial Stock ETFs and What Else? (1-Month Returns)
Approx %
SPDR Select Sector Financials (XLF) 7.7%
SPDR Homebuilders (NYSEARCA:XHB) 6.5%
SPDR Select Sector Technology (NYSEARCA:XLK) 5.8%
Vanguard Information Tech (NYSEARCA:VGT) 5.0%
iShares S&P Global Financials (NYSEARCA:IXG) 4.4%
iShares MSCI All-World (NASDAQ:ACWI) 2.2%
Vanguard Europe (NYSEARCA:VGK) 1.8%
Vanguard Extended Market (NYSEARCA:VXF) 0.9%
iShares Russell Microcap (NYSEARCA:IWC) 0.3%
SPDR Select Sector Energy (NYSEARCA:XLE) -0.8%
Vanguard Emerging Market (NYSEARCA:VWO) -1.6%

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.