More Than Meets the Eye: Financials

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"Don't judge a book by its cover." We've all heard that. The basic message is that one must look beyond just the surface to discover truth.  This is especially good advice when looking at sector exchange-traded funds (ETFs).

The financial sector has outperformed the broader S&P 500 since the June 2012 lows, up 14% versus an S&P's gain of 8%.  But there certainly is more than meets the eye when it comes to the financial sector's performance.

The Large Financial Sector

As of the September quarter end, the Financial Select Sector SPDR (XLF - News) makes up over 15% of the S&P 500 by market weight.  It's the second largest sector by market cap, behind Technology at 19%.  A summary of those sector weightings is best captured in the chart from Standard & Poors (SPY - News) below. 

Most investors are aware of the immense size of Apple (AAPL - News) in the Technology sector with 24% of the sector's weighting.  But many are not aware that there are similar dynamics occurring in the financial sector, albeit the domination is not by one single company, but by an elite few.

Financial Sector Weightings

The S&P 500's financial sector as of 11/3/12 is made up of 82 financial companies and weighted based on market cap (stock price x shares outstanding).  However, just the top 10 financial companies out of the entire 82 make up a full 50% of the XLF's market cap. 

Furthermore, 5 stocks constitute 36% and just 3 stocks make up over 25% of the XLF's value.  Similar to Apple's dominant position in Technology, investors can follow just 3 key financial companies to help decipher the fate of the financial sector indices.

The spreadsheet captures the breakdown of the financial sector by market cap weighting including the top 10 companies in the index.

The Key to the Financial Sector

The chart below shows the top 5 index constituents along with XLF and shows the vast difference in performance in financial companies.  Since the June lows, 3 of the top 5 companies in the sector, making up 20% of its weighting, have far outpaced the other financial companies, up over 25% each and lifting the index (in purple) over the past few months.  Citigroup (NYSE:C) in black, Bank of America (BAC - News) in red, and JPMorgan (JPM - News) in green have led the XLF significantly higher over the past few months. 

The more traditional banks such as Wells Fargo (WFC - News), and financial conglomerates such as Berkshire (BRK-B - News) have dragged the index down, underperforming their index by 5 percentage points+.

An investor can follow these three financial companies to get a better handle on where the broader financial index and thus markets are headed.

Why the Financials Matter

In articles written on 8/17and 9/26 we showed how the Financial and Energy (XLE - News) sectors were the key to the market's continued rally.  We also alerted our subscribers on 7/21 In our August newsletter how these sectors led the market higher and lower over the past two months and how they would also lead to the downside.  "Their underperformance and breakdown in early May helped identify the market's change in trend from up to down and we are expecting a similar event at the market's next juncture. Until these sectors break down, the market's top likely is not in place."

After 4 months, these sectors continue to lead the markets higher, barely; the financials with the help of its top 5 holdings.  Once these large financial companies break down from their impressive strength since June, we expect XLF and thereafter the broader markets to confirm that a near-term top is in place.

The ETF Profit Strategy Newsletter uses relative strength analysis along with common sense technical analysis to provide a short, mid, and long-term forecast along with actionable buy/sell recommendations.  This helps us identify key trend changes in the sectors as well as the broader markets.

Follow us on Twitter @ ETFguide



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