A key sector's persistent underperformance is sending a warning signal to the market even as the S&P 500 repeatedly reaches new record highs.
The U.S. financial sector has declined approximately 6% year-to-date, while the S&P 500 has gained 7% over the same period, closing at a record high in 14 of the past 17 trading sessions. This unusual divergence has raised concerns among some market participants, as similar signals preceded the dot-com bubble burst and the 2008 financial crisis.
"The U.S. stock market cannot sustain itself without support from the financial sector," stated Scott Brown, founder of Brown Technical Insights. Historical data indicates that financial stocks need to at least participate in a rally, but currently, they are not even doing that.
Worries in the private credit market are considered a significant factor pressuring the financial sector. Melissa Brown, Global Head of Investment Decision Research at SimCorp, noted that the financial system is highly interconnected, and associated risks "could spread more widely than currently anticipated," requiring close monitoring. Despite major banks like JPMorgan Chase, Bank of America, and Wells Fargo reporting strong quarterly earnings in April, the downturn in the financial sector has persisted.
Technical Divergence: XLF Falls Below 200-Day Moving Average Scott Brown highlighted that the technical signals for the financial sector are particularly concerning. The State Street Financial Select Sector SPDR ETF (XLF), which tracks the financial sector, has not only declined while the S&P 500 hit new highs but has also remained below its 200-day moving average—a key indicator widely used to gauge long-term trends.
Historical data shows that in the 32 previous instances where the S&P 500 reached a new high while XLF was simultaneously below its 200-day moving average, the S&P 500 declined 29 times one month later, with an average drop of 3.3%. Six months later, the S&P 500 was down 18 times and up 14 times; one year later, while it was up 17 times and down 15 times with an average gain of 4.6%, the maximum loss during the declining periods reached 41.5%, indicating an asymmetrically high downside risk.
Furthermore, among all 11 SPDR sector ETFs tracking the S&P 500, XLF is currently the only sector where both its price and 50-day moving average are below the 200-day moving average. This suggests the financial sector is weak in both short-term and long-term trends.
The relative performance outlook is equally pessimistic. According to data from FactSet and MarketWatch, since XLF's inception on December 22, 1998, its performance relative to the S&P 500 has fallen to its lowest level in history.
This means the financial sector's current weakness relative to the broader market is more severe than during the COVID-19 pandemic shock and the 2008 financial crisis, and far worse than at the beginning of the dot-com bubble burst in 2000. This extreme relative weakness is causing unease among some analysts.
Historical Precedents: Financial Sector Issued Early Warnings Twice Before The financial sector is viewed as a leading indicator due to its core role as a provider of economic liquidity. Businesses require loans to expand, and banks profit from lending. When credit conditions tighten or lending willingness declines, the economy and stock market often face pressure.
Historically, the financial sector issued early warnings twice before major market peaks. Before the dot-com bubble burst, XLF's relative performance against the S&P 500 began weakening in April 1999, approximately 11 months before the S&P 500 ultimately peaked. Before the 2008 financial crisis, XLF started sending warning signals in February 2007, about 8 months ahead of the market top.
In response to these signals, Scott Brown advises caution rather than aggressive action. He noted that calling a market top is difficult in the current environment, and turning bearish is challenging because such warning signals can persist for a long time before being digested by the market, and sometimes may not materialize at all.
However, he suggested investors might consider gradually "reducing exposure to chip stocks" instead of continuing to chase gains, and should avoid injecting new capital into the market. JPMorgan Chase CEO Jamie Dimon previously compared the private credit issues that emerged late last year to "cockroaches"—if you see one, there are likely more behind it—though he also stated these problems might not pose systemic risks. The market's overall reaction to this warning has been muted. Yet, against the backdrop of the financial sector continuously sending abnormal signals, this warning may deserve renewed scrutiny.
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