Monday, February 27, 2006

US Financial Stocks Lead S&P Herd

Sector's Dominance Bodes Better than Energy-Industry Strength, but Rising Interest Rates Pose Risk

The Wall Street Journal, E. S. Browning, 27 February 2006

With oil prices back above $62 a barrel, oil stocks are in vogue. Exxon Mobil once more has surpassed General Electric as the biggest stock, with a market value of more than $375 billion, compared with GE's $350 billion. Microsoft and Procter & Gamble trail well behind. So do Citigroup and Bank of America.

But as a group, financial stocks -- not energy stocks -- dominate the Standard & Poor's 500-stock index. Banks, stock brokers, insurance companies and the like make up 21% of the index's market value. Technology is next, followed by drug and other health-related stocks, according to data compiled by Birinyi Associates in Westport, Conn. Energy stocks, for all their gains, come in sixth, with 9%.

And that is good news for the stock market, because financial stocks have longer coattails.

When oil stocks are dominant, as they were in the 1970s, it is because oil prices are so high that other parts of the economy suffer. When financials are strong, it is because inflation and interest rates are low. That is great news for banks and insurance companies because it holds down their cost of obtaining funds. And low interest rates hold down costs and boost profits at most other companies, too. That is why investors love to see financials lead the market.

"Financials are a good bellwether for the rest of the market," says Jack Ablin, chief investment officer at Harris Private Bank in Chicago.

The question is whether financials are going to stay strong and keep leading stocks higher. On that subject, Mr. Ablin and some others have worries.

Every decade, it seems, a different group of stocks takes command. The 1970s were a miserable period for most stocks, with oil prices soaring, some Arab oil exporters temporarily cutting off supplies, and lines to get gasoline snaking around city blocks. Oil stocks dominated the market. Back then, energy companies represented more than 20% of the S&P 500.

In the 1980s, as big consumer companies like Coca-Cola expanded world-wide, consumer stocks led. In the 1990s, it was technology stocks.

Now, although oil stocks are moving up again -- in the 1990s, they were just 5% of the S&P -- oil companies are nowhere near as important to the economy as they used to be. Service companies, particularly financial services, play a much bigger role. Which stock group dominates in the future will tell a lot about the market's direction.

"To get the broad market to go to new highs, you are absolutely going to need to see leadership come from the financial sector and see those stocks do well, so that their gains translate into the broader market," says Stephen Sachs, director of trading at mutual-fund group Rydex Investments in Rockville, Md.

If the world economy overheats, or if oil supplies are disrupted, oil stocks could benefit, and the rest of the market would suffer.

Last week, as oil futures pushed to $62.91, their highest level in more than two weeks, investors seemed uncertain which way stocks were headed. The Dow Jones Industrial Average finished at 11061.85 -- just short of a 4½-year high, but down 0.5% on the week, including a decline of 7.37 points on Friday. The average still is up 3.2% since the year began.

Hoping rates will stay low by historical standards, investors worry about how high the Federal Reserve will push them. The yield of the 10-year Treasury note remains less than 4.6%, for example, even though consumer prices rose 4% over the past 12 months. That means money remains very inexpensive.

The question is whether inflation fears will prompt the Fed to keep raising rates and choke off all this easy money, or whether it will be able to stop while rates remain relatively low, permitting the economy to remain robust. That is where the worries come in.

Some investors fear the Fed won't stop raising rates until some kind of financial blowup occurs, as was the case in 1998 when Russia defaulted on its debt and investment fund Long-Term Capital Management collapsed, almost taking the bond market down with it.

In a report to clients last week, New York research and brokerage firm International Strategy & Investment warned that people shouldn't buy financial stocks until they see clear signs the Fed is finished raising rates.

"Previous cycles have shown us that the sector does not begin to consistently outperform until after the Fed is done and is closer to easing rates," ISI investment strategist Jason Trennert wrote in the report.

A big problem for financial companies is that short-term rates have risen faster than long-term rates, which is squeezing financial firms, notes Mr. Ablin of Harris Private Bank. Financial firms tend to borrow at short-term rates and lend at long-term rates. When the two move close to each other, financial firms' profit margins get squeezed. As long as the Fed keeps raising short-term rates, the problem is likely to persist.

Mr. Ablin says investors are blasé about that. Low interest rates make it inexpensive to borrow and invest, which makes people too tolerant of risky investments, he says, and which could threaten profits at financial companies.

"Right now there is too much complacency" about risk, he says. Junk bonds are selling for yields that are only about 2.25 percentage points higher than those of virtually risk-free 10-year Treasury bonds, compared with a 4.5-point differential in more normal times. That could be a sign of trouble to come, Mr. Ablin says.

He forecasts stock-market gains in the low single digits this year, which would mean that many of the gains already have been registered. He fears that technology stocks and small stocks may show a decline for the year, as the economy slows.

Adds Mr. Sachs of Rydex, "Given the interest-rate environment we are in now, the question is whether financial stocks can continue" to do well.