What happens in markets when Financials are the worst performing sector?

Entering 2016, nothing particularly good. We saw this in 1990, 2007, 2008, and 2011.

1990 marked the start of the 1990-91 recession.

2007 marked the start of the 2007-09 recession.

2008 was the worst year in markets since the Great Depression.

The S&P 500 would finish slightly positive in 2011, but not before a harrowing 20% peak-to-trough decline during the year.

(Click on image to enlarge)

In 2016, Financials have been lagging the market for the entire year. Back in February, with the S&P 500 down over 10%, they were the worst performing sector. Many viewed this as an ominous sign of another difficult year. Since then, the S&P 500 has rallied over 22% to reach new all-time highs.

And how are Financials doing? They’re still in last place.

Shocking, I know. How can the broad market be doing so well while Financials still seem to be struggling?

There are likely a few factors at play.

First, Financials are just one input into a highly complex system. There is no law that states the market “has to” go down when Financials are lagging. Relative weakness may have increased the odds of a broad market decline in prior years, but that is not the same thing as saying the odds were anywhere near 100%. Also important here is to note that the stock market can go down without Financials being weak. We saw this in 2000-02 when the S&P 500 was down each and every year while Financials were never in the bottom third in terms of sector performance. So even if Financials were not weak here, it does not mean you should let your guard down.

Second, the continued relative weakness in Financials since February has coincided with a positive conflicting signal: the vast improvement in credit markets (see high yield spreads below). This is important because a big part of the concern when Financials lag is that it could be indicative of worsening credit conditions. This time around, that doesn’t seem to be the case.

This brings us to the third and perhaps most important explanation. Financials may just not be as meaningful to the broader economy and stock market as they used to be. This is difficult to prove, but as a result of what seems to be an unending increase in regulation, Financials have become more Utility-like in terms of their growth prospects. Revenue growth has been flat for years and cost cutting seems to be more of a driver of the bottom line than anything else. If this is true, the sensitivity of Financials to the broader economy is lower than in the past, which in turn would make the behavior of financial stocks less indicative of overall market behavior.

Does that mean that Financials are irrelevant when it comes to overall stock market performance? Certainly not. At 15.7%, they are still the 2nd largest sector in the S&P 500 Index and if they were to crash from here it would be a significant problem.

But absent a crash in Financials, the mere fact that they are underperforming does not seem to be a major issue for markets. Interestingly, that is not wholly inconsistent with market history as the S&P 500 has advanced over 1000% since October 1989 while the Financials have been the 2nd worst performing sector. I realize that doesn’t jive with conventional wisdom but the truth when it comes to markets rarely does.