Financials are surging, and that's a good thing

Key points:

• S&P 500 financial sector members at a 21-day high exceeded 69% on Wednesday
• The surge outpaced the number of S&P 500 new highs by over 30%
• When financial sector breadth is strong, it bodes well for financials and the broad market 

Financials as a risk-on barometer

In a note on 7/25/22, I shared how I use the percentage of S&P 500 members at a 21-day high to give the all-clear sign coming out of a bear market. The signal eventually issued an alert on 7/29/22, which I reviewed in a TCTM update. 

We now have additional evidence to suggest that the bear market could be transitioning to a cyclical uptrend as S&P 500 financial sector members at a 21-day high surged above 69% on Wednesday. Let's assess the performance of the S&P 500 financial sector and the S&P 500 following previous occurrences of this setup. 

A surge in financial sector member 21-day highs is good for financials and the broad market

The study generated a signal 68 other times over the past 71 years. S&P 500 financial sector returns, win rates, and z-scores were excellent across all time frames, especially on a long-term basis. Interestingly, the signal rarely triggered an alert during the inflationary 1970s.

Applying the signals to the S&P 500, the results look excellent across all time frames. So, what's good for financials is good for the broad market. Besides one untimely signal in 2008, the alert did an excellent job of avoiding whipsaw situations during bear markets.

Let's add some context to the signal. As 21-day highs for S&P 500 financial sector members surged above 69%, the number of 21-day highs for S&P 500 members increased to just over 38%. So, the spread between the two groups was over 30%.

Let's identify when 21-day highs for the S&P 500 financial sector members increase above 69% and the spread between 21-day highs for S&P 500 financial sector members and S&P 500 members is greater than 30%.

The new study identified 48 instances over the past 71 years. S&P 500 financial sector results look even better than our original analysis, with higher returns and win rates across most time frames. The signal had a positive return at some point in the three or six-month time frames in 42 out of 47 instances.

When I apply the signals to the S&P 500, we see excellent results and consistency. Since 1958, the S&P 500 had a positive return at some point in the three or six-month time frames in 33 out of 34 instances.

What the research tells us...

Financials are an excellent risk-on barometer for the broad market as the sector is essential in transmitting credit, which fuels the economy. So, whether it's breadth thrust signals for stocks and high yield bonds, small-cap stock performance, and now a surge in 21-day highs for financials, the weight of the evidence continues to build in favor of a new cyclical uptrend for stocks.