Every month we look at price correlations across a variety of asset classes and sectors, and today we’ll look at large cap banks (using the S&P Banks Index/KBE ETF) and their smaller brethren (S&P Regional Banks Index/KRE ETF). The point of this analysis:
- Bank stocks are usually early cycle stock market outperformers and, given that US financial institutions are better capitalized now than at any point in the last +20 years, they should provide market leadership this time around as well.
- But… yesterday’s bank stock performance was pretty dreadful, with the Banks Index down 5.1% and Regionals down 5.6%. Not the sort of price action one likes to see a day before earnings reports start.
- While government programs like PPP and larger unemployment checks will help sustain the US economy, access to credit is the fundamental engine of American economic growth. As long as bank stocks remain under pressure, the market is signaling that all is not well with this conduit.
- Also worth mentioning: banks are the largest single piece of the S&P 500 Value Index (8%) and a truly outsized part of the Russell 2000 Value Index (20%). Banks will have an outsized impact on when the Value trade starts to work.
We created 2 charts with the historical price correlations for the KBE ETF (large banks) and the KRE ETF (small banks) versus the S&P 500. We use daily price returns and trailing 90-day correlations to the index. Here is what we see in the data:
#1: Large/small bank stock return correlations to the S&P 500 are at 0.92 and were as high as 0.95 in mid-March, basically the same as their all-time highs back to 2006. Remember: correlations can only go to 1.0, and the average correlations since 2010 are much lower than now (0.76 for large bank stocks, 0.72 for small bank stocks).
#2: The only other time we’ve seen bank stock correlations to the S&P 500 this high was in Q4 2011 during the Greek debt crisis. They were over 0.9 from mid-August 2011 all the way through to January 2012 (for small caps) and mid-March 2012 (for large caps).
#3: It was only after these correlations started to break apart that Financials led the S&P higher in 2012, 2013 and 2014:
Large cap Financials: +28.8%
S&P 500: +16.0%
Large cap Financials: +35.6%
S&P 500: +32.4%
Large Cap Financials: +15.2%
S&P 500: 13.7%
The bottom line here: sector correlations decline when industry fundamentals start mattering more to stock returns than general market conditions, so it makes sense that Financials led the market higher once we got past 2009 – 2011. The initial move off the bottom for US stocks post-2008 was more about “the world did not end” than anything else, after all.
That means Financials are the group to watch, the stocks that signal when real economic recovery is taking place. History says we may have to wait a few months to find an investable level for the group, but the fact that correlations are so high just now shows the clock has at least started.