What Financials, Tech ETFs Tell Us

For all of the attention that the energy sector has attracted in recent months, that sector is not what will determine the trajectory of the broad stock market. Technology and financial stocks might offer better clues.

That’s Nick Colas’ assessment, chief market strategist at Convergex, a global brokerage company based in New York. His points are these: First, energy has a weighting of only 7% in the S&P 500. Technology and financials are at 21% and 17%, respectively. What happens in the latter two is far more significant to the overall performance of the S&P 500 than what happens to energy.

Correlations Rising

Secondly, Colas noted that correlations are on the rise—the highest since late last summer when the market was up in arms as China’s stock market crashed. That trend has been largely led by financials and technology stocks.

In the past 30 days, the average S&P 500 sector correlation reached 86.7%, exceeding the 12-month average of 82.6%, according to Convergex data. Technology and financials are showing correlations around 96-97%, while energy is around 66%.

“The recent selloff in risk assets and commodities is doing what every decline has done since the Financial Crisis: push financial asset price correlations much higher than long-term historical norms,” Colas said in a research note.

‘Risk-Off Metric’

“Asset price correlations are essentially a measure of just how ‘Risk off’ the market is trading. And right now, the needle on this measure is quivering at the high end of the range,” he added. “The most important takeaway from this analysis is that U.S. equities don’t need energy stocks to lead the market higher.”

On the contrary, energy could very well “decouple” from the broader market, according to him, and it’s already showing signs of doing just that, if recent performance is any indication. Earlier this week, the energy sector, as measured by the performance of the Energy Select SPDR (XLE | A-91), hit a five-year low, while the SPDR S&P 500 (SPY | A-98) is down to levels seen as recently as last fall.

“By this measure, near-term volatility can still get worse,” he added. “As for which sectors bear watching for a turn, investors are probably too focused on energy. Technology and financials have higher correlations and much larger weighting in the index.”

What All This Means

So what does all this tells us about what’s ahead for the market? For starters, probably more short-term volatility due to the correlation levels.

The market is still concerned about China—a market that continues to make waves and has seen two days of halted trading this month alone due to sharp declines—and oil prices, which continue to soften. The pace of interest rate hikes, and worries about lofty U.S. stock valuations all add to investor jitters going forward, Colas says.

And if you follow the money, ETF asset flows would suggest that the market has yet to bottom. Since the first of the year, ETF investors have yanked roughly $1 billion from U.S. financial ETFs and $1 billion from tech ETFs, according to Convergex data.

The Financial Select SPDR (XLF | A-92) alone has seen $590 million in net redemptions year-to-date, while the Technology Select Sector SPDR (XLK | A-91) has bled $740 million.

Those redemptions have come as the funds delivered weak performances:

Chart courtesy of StockCharts.com

“Money flows rarely turn quickly, so we probably have some distance to travel before these groups, and the market as whole, has bottomed,” Colas said.

Buyers Need To Return

“While ETFs aren’t the whole money flow picture in U.S. markets, the outflows here are both noticeably larger than usual and entirely in concert with both equity returns and the correlations we noted,” he noted. “To get some/any of these other sectors to start moving higher, however, we’re going to need some incremental investor interest in buying these groups.”

The good news is that many are projecting a good year for financials and technology sectors—the first set to benefit from a rising rate environment and the latter a likely source of positive earnings growth.

State Street Global Advisor’s Head of Research for SPDR ETFs Dave Mazza is in that camp. He shared his views in an interview with ETF.com that’s worth a read.

Contact Cinthia Murphy at [email protected].