In this issue of the Connors Research Traders Journal, we’ll look at a recent paper from the Federal Reserve which shows statistical evidence that the financial stocks are a leading indicator for both stock prices and economic cycles.
In the pre-quant days, when observations were rarely quantified, professionals relied on certain types of inherent conditions to guide their trading and investments.
One of the main themes that was repeatedly discussed was that financial stocks lead markets. A healthy financial system (especially banks), were said to lead to markets rising, and an unhealthy system eventfully leads to markets declining. Kevin Haggerty, who was the head of trading at Fidelity Capital Markets in the 90s, used to preach about this to me, and on the TradingMarkets website for years.
We only have to look at the financial conditions which preceded the 2008 market crash for this as an example of the wisdom of “follow the financials”.
Now, we have empirical evidence of this in a new study published by the Federal Reserve. The following study was sent to me from a friend who is a head strategist for one of the largest investment firms in the world. He sees some of the very best research studies available and whenever he sends me something new, I know it’s worthwhile.
In this study titled “Stock Market Cross-Sectional Skewness and Business Cycle Fluctuations” by Thiago R.T. Ferreira you will see quantitatively that over the past 90 years, the SKEW in the financial industry stocks has been the leading indicator for predicting stock prices and future economic conditions. Here is the study.
https://www.federalreserve.gov/econres/ifdp/files/ifdp1223.pdf
A few observations:
1. If you’re thinking of only applying XLF as a proxy, it’s likely insufficient. It’s overweighted in a handful of large banks and its construction doesn’t fully allow for getting into the heart of the financial system.
2. Include regional banks and community banks in your analysis.
3. Include lending companies and large transaction companies like Visa (V), Mastercard (MA), and American Express (AXP) to further see the flow of money.
4. Even though this paper shows that the financial industry stocks lead (and I fully concur), the Technology industry and the Basic Materials industry also play roles (they’re secondary complements to the financials). In the pre-quant days the technology sector and the basic materials sector were also mentioned with financials as being the leading indicators for future stock market movement. This was played out for example with technology leading the market on the way up in 1997-2000 and leading it on the way down when the internet bubble burst in the spring of 2000. More recently Basic Material stocks led the post-2016 election. Being cognizant of the behavior of what was referred to as “The Big 3” remains valid today.
I hope you enjoy this paper presented by the Federal Reserve and find ways to apply the behavior of financial stocks to your trading in order to increase your profits. For those of you who don’t fully follow the math in the study, the abstract and conclusion will guide you.
Enjoy your trading!