Financial Stocks Could Jeopardize The Rally
-- August 25, 2003

The Dow Jones Industrial Average fell today on the ubiquitous excuse of "profit taking." After all, said one analyst, "The market has done very well year to date. I don't think there is anything I can really point to that would specifically cause the market to drop." But it's precisely because the market has done so well, and expectations for future gains are so high, that we're concerned that what's going on is more than "profit taking."

The financial stocks, which have led this rally, are raising the most red flags. Key financial stocks JP Morgan, Citigroup, Wells Fargo, and Merrill Lynch peaked in July. All of them look to be headed lower and have ugly chart patterns to boot. It could be the catalyst that leads to a sharp correction in the stock market, or possibly an end to the rally.

Financial stocks comprise 21% of the S&P;, by far the single most important group in terms of market cap and leadership. The group peaked in mid-June, coinciding with a 45-year low in US interest rates. We doubt it's a coincidence. The sharp rise in rates since that time could easily hammer profits in the financial sector.

Banks and other financial firms loaded up on Treasury bonds and mortgage-backed securities to ride the rising tide of bond prices. The rally in bonds propelled earnings in the financials. But keep in mind, playing the bond market for profits is a dangerous double-edged sword.

When interest rates rise faster than expected, it leads to a mismatch in assets and liabilities among financials i.e. there cost of funds rises faster than the profit margins on loans. But the real hit to earnings for the group comes from the swift erosion of the investment value of their bond portfolios.

This is a concern for two reasons. First, the economy relies heavily on continuing credit from banks to keep greasing the wheels of recovery. When banks have internal problems, they often reduce their loans by raising credit standards. And second, financials have led nearly every bull market in market history. But now it looks like the financials could lag in a big way. So even if we see a recovery, it could be lackluster indeed.

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