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The Weighting Game

Financials are the largest sector in the market, but headwinds are growing

William Hester, CFA
October 2004
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Market analysis is a bit like stadium seating for sporting events. While it's fun to be in the first row watching the action up close, the better seats are often in the mezzanine where you can watch plays develop.

One example of mezzanine analysis is tracking how the weight of an industry in the S&P 500 changes over time. It needn't be a daily exercise. A move of one percent over a calendar quarter is noteworthy. But it's time well spent because changes in investor preferences are often subtle and slow moving and not always obvious from daily movements in the markets.

Individual sectors can be weighted and ranked by their market value. Sectors, like company weightings, are top-heavy. The top 5 groups make up 72 percent of the total value of the S&P 500.

Financial companies currently hold the largest share of value in the index, followed by the Information and Technology, Health Care, Industrials, and Consumer Discretionary groups.

Sector weights are partially determined by investor optimism. As the prospects for a sector improve, so will its relative position within the index. The weighting of energy companies has jumped two percentage points in the past year as investors have become increasingly bullish on the group.

Like any ranking, first place is often difficult to maintain. Today's two largest groups – financials and technology - have a history of dueling for the top spot.

From 1996 through 1998 the financials had the largest weighting. Then the third quarter of 1998 arrived: Russia's currency devaluation, the turmoil in Asian financial markets, and Long Term Capital Management's blow-up all sent the stocks of financial companies reeling.

Of course, at that time the Internet revolution was at full speed, which helped the Information and Technology Index breeze by the struggling financial group. Technology-related stocks eventually reached nearly a third of the benchmark index's weight.

By the beginning of 2001 it became clear that the earnings of technology companies were not destined to represent half of the economy, and that the rate of growth in these profits was actually slowing. The shares of technology stocks fell back to earth, and financial companies resumed their top spot.

Headwinds

From the standpoint of profits, it might seem logical for financial companies to hold the largest market weighting. Nearly 30 percent of the operating profits of the S&P 500 come from the financial sector. This is up from 21 percent at the end of 2000.

But profit share alone does not guarantee the financials the top spot by market value. In fact, their weight is slipping.

At the end of September, the group made up 20.5 percent of the S&P 500's market value, down from a quarterly high of 21.6 percent in March. During this period, financial stocks fell 3.3 percent, the seventh worst showing of the 10 sectors, and outpacing the markets drop of 1.2 percent.

Investors may be pricing in deteriorating earnings growth. Profits for the entire group may be set to slow, say analysts polled by Thomson Financial. Following 12 percent profit growth this quarter, the earnings of financial companies should rise just 8 percent next quarter. By the first quarter of 2005, year over year earnings are expected to grow by just 1 percent.

The S&P Financials Index is made up of a diverse group of companies. It includes Wall Street banks, community banks, credit card companies, insurance companies and real estate concerns. It's impossible to paint the outlook of these diverse businesses with one brush stroke.

But the environment for a large swath of them is worsening. As Bridgewater Associates notes, financial sector profits have grown partly because the level of financial assets and liabilities as a percent of GDP has steadily grown. This was “primarily due to falling interest rates and good profit growth. It is unlikely that interest rates can keep falling and that profit growth will be as strong.”

Another headwind the group faces is the spread between short and long rates. As long-term interest rates have declined over the past five months, short-term rates have risen or moved sideways. This has narrowed the spread between these two extremes of the yield curve.

Many financial companies are in the business of borrowing at short-term rates and lending at long-term rates. A flatter yield curve makes profits from these transactions tougher to come by. Over the last four and half years, a period that contained both an inversion of the yield curve (short-term interest rates higher than long-term interest rates) and a dramatic widening between short and long rates, the correlation between the operating earnings of financial companies and the steepness of the yield curve has been about 60 percent.

There are other hurdles for the group. Banks – a subset of the S&P Financial Index – look particularly sensitive to the health of the housing market. When Fannie Mae and Freddie Mac are included, nearly 40 percent of the revenue earned by the banking group comes from mortgage-related business, according to Bloomberg data.

Few economists expect the housing market to continue to rise at its recent pace. There are already some signs of slower growth. New home sales, though still strong, hit their high in March. Existing Home Sales hit their most recent peak in June.

The relationship between the housing market and bank stock performance shouldn't be ignored. There's been a 90 percent correlation between the S&P 500 Bank Index and the Bloomberg US Home Builders Index since March of 2000. Of the thirty-two sub-industry groups that Standard & Poor's tracks, only the Consumer Durables Index has had a tighter correlation with homebuilders.

Losing Status and Performance

More than status is on the line for sectors holding the top spot. Following the last three changes in leadership, the shares of the group overtaken have under performed the shares of both its successor and the overall market.

Back in 1996, the financials group overtook consumer discretionary companies. Over the next two years the financial group nearly doubled in value, while the market rose 60 percent. Consumer discretionary stocks rose 45 percent during the period.

Technology stocks doubled in the fifteen months after they took the top spot in 1999. Financial stocks were flat during this period, while the market rose 20 percent.

Since the financials group regained the lead in March 2001, their shares have risen 15 percent while the market has gained 1 percent. The shares of information technology companies have dropped 18 percent.

Financial companies still have plenty of breathing room. They make up a fifth of the index and sit 5 percentage points ahead of technology companies. But if the housing market cools, and the curve flattens further, the competition for the market's top spot may turn into a tight race.


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