Too Big To Fail In Action

Includes: SPY, XLF
by: Bespoke Investment Group

The chart below shows the relative strength of financial stocks based on market cap relative to their respective market cap indices. The red line in the chart represents the relative strength of the S&P 500 financial sector vs. the S&P 500, while the gray line represents mid-cap financials, and the blue line tracks small cap financials. When the line is rising it indicates that financials are outperforming their respective indices, while falling lines indicate underperformance.

In today's press conference Fed Chairman Ben Bernanke said that he agrees with the premise that "too big to fail" remains a problem in the financial sector. What he means by this is that because America's largest banks are so large, any failure would pose a systemic risk to the financial system. Because of this, there is an implicit (if not explicit) government backstop for them. At the same time, because smaller banks pose less risk, they are not "too big to fail."

How does this "too big to fail" conundrum play out in the market? As shown in the chart, clearly investors are more comfortable investing in large cap banks. While large caps have been outperforming the S&P 500 by a wide margin, small and mid-cap financials are only performing in line with their respective indices.