Earnings season begins next week, and as always, the big banks will be leading the way. Here’s what this tape is telling me: Over the past four weeks, the rotation of the financial industry relative to the broader market has improved.
Information technology (which has been the market leader for as long as anyone can remember) flattened out four weeks ago and has remained depressed for the past three weeks. Relative strength doesn’t come overnight. It tends to develop over time and can sometimes give off false signals (see the attached video to see what I mean). But taking advantage of it requires some foresight and potential catalysts, and we’re on the verge of getting some.
The Financials Select Sector Index trades at about 15.5 times forward earnings, about a turn and a quarter below its 2024 stock price. Is this the lowest level in the history of financial products?No. However, the group has tripled its adjusted earnings per share over the past decade. If estimates are revised upwards following this season’s results, and if improving credit, capital market activity, and net interest rate trends suggest this is likely, then that multiple will look even more attractive.
The hot trade of the past two years has been AI, and as we’ve seen, it’s an exercise in stock picking. You need to identify winners and losers. These days, hardware is generally the winner and software and services are the losers. Finances, on the other hand, are a little more straightforward. If the economy is doing well, the economy in general is also doing well.
The AI story in technology requires correctly handicapping which companies will recoup the spend, how big it will be, how long it will last, and whether it can be successfully monetized. Your finance person won’t ask you to do that. These are games that leverage nominal growth itself. There is no need to identify the winning horse. What’s even more difficult is that you don’t have to find the needle in the haystack. You just own the haystack.
The reason this is doable now is because the implicit correlation is historically low. We mentioned implied volatility earlier, and this is how options traders think about option prices. Implied correlation is how an options trader thinks the price of an option on a basket of stocks compares to the price of an option on stocks in the basket. When is “implicit correlation” high? It simply means that the option price on the basket is high compared to the option price of the stocks included in the basket. What if the implicit correlation is low? Just the opposite is true. Simply put? Options on NDX, SPX, and sector indexes are better than options on individual stocks.
Financial Select Sector SPDR, year-to-date
Because option premiums are low in baskets, it’s time to buy options outright in ETFs, rather than reflexively diversifying them or trading them in a single name. With XLF trading at about $55.50, the August ’56 calls can be purchased for about $1 (less than 2% of the ETF price) for a six-week exposure spanning the heart of earnings season.
