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The Financial Complex

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How important is the broader financial sector? It currently accounts for 17.64 percent of the S&P 500 (SPX), second only to information technology, which accounts for 18.00 percent. More important than its weighting in the S&P 500, the financial sector is the pulse of the U.S. economy. The banks lend to consumers and businesses. The brokers lend to and underwrite for new businesses. The brokers also transact trades. And the insurers...well, they insure.

There is a lot at play in the financial sector. The Fed is reportedly nearing the end of its benign monetary policy, which it adopted about one year ago. The Fed meets next on December 11. Will they or won't they cut rates again? That question if of concern to the banks who borrow at the overnight Fed Funds rate and lend at a higher rate, in turn capturing the spread. The companies most levered to short-term rates are the savings and loans, such as Washington Mutual (NYSE:WM) and Golden West (NYSE:GDW). The two stocks are almost pure plays on interest rates. Recently, shares of the two savings and loans have been predicting an end to falling short-term rates. Washington Mutual and Golden West are components of the Bank Sector Index (BKX) and have been weighing on the group recently.

The Bank Sector Index had been one of the stronger, better performing groups until about a week ago, when the Enron (NYSE:ENE) and Dynergy (NYSE:DYN) deal fell apart. The termination of the deal sent Enron into bankruptcy. That's a problem for the big corporate lenders because Enron is laden with debt. It owes Citigroup (NYSE:C) $3 billion, Bank of New York (NYSE:BK) $2 billion, and J.P. Morgan Chase (NYSE:JPM) $1.9 billion. The three aforementioned money-center banks are components of the Bank Sector Index.

Obviously the Enron bankruptcy filing over the weekend has an adverse impact on its creditors. Will they get their money back? The banks had been rallying in anticipation of an economic recovery next year, but the Enron debacle halted the rally. Since Enron took a turn for the worse, the BKX broke down below support at 830 and is lower again this morning. Next stop could be between 800 and 815.

The brokers have exposure to Enron, but not to the extent that the banks do. Still, the Securities Broker/Dealer Index (XBD) has tracked the BKX closely over the last week. In addition to the Enron pressures, three high-profile brokers were downgraded this morning. Goldman Sachs lowered its '02 estimates on Morgan Stanley (NYSE:MWD), Merrill (NYSE:MER), and Lehman (NYSE:LEH). Goldman's broker analyst based the downgrade on valuation concerns and two weak business segments: retail brokerage and mergers and acquisitions. The XBD was also rallying on the prospects of a pick-up in the economy next year, and the impact that would have on the brokerage business. It's sliding below its early November levels this morning.

The insurers have been the strongest of the three sub-sectors that comprise the broader financial sector. The Insurance Sector Index (IUX) flirted with its relative highs around 740 last week. The IUX is stronger than the BKX and XBD again this morning.

The insurers, while faced with an estimated loss of $70 billion from the World Trade Center devastation, have benefited from a substantial hike in premiums. The IUX's recent rise is attributable to supply and demand. The demand for insurance has risen in the wake of the terrorist attacks, while the supply of insurance has fallen because the insurers are taking less risks. As a result, premiums have risen and so has the IUX.

Of the three in the financial complex, the IUX is the strongest. The insurance business was entering a long-term cyclical up-turn before the terrorist attacks. The events of 09/11 only exacerbated the rally in the business. The insurance sector, however, isn't as levered to the business cycle as the banks and brokers.

The banks and brokers are excellent indicators of the health of the U.S. economy. They can also be used for insight into short-term market direction. The BKX and XBD staged substantial advances in the last two months. So did the market. Maybe Monday's breakdowns in the two are nothing more than routine profit taking after the big runs. If so, the price action of the BKX and XBD may foretell of further weakness in the broader market as measured by the S&P 500. Backing and filling is part of the natural process.

However, another scenario that could explain the sell-off in the banks and brokers is that their weakness could be foretelling of a less-than-inspiring economic recovery next year. Surely the Enron debacle is contributing to the weakness in the two, but the event should only impact the two sectors over the short-term. What you will want to watch for over the next several weeks is for a rebound in the BKX and XBD, which would indicate that the economy is on the mend in a big way. The price action of the BKX and XBD should help to reveal how strong the economic recovery will be next year. Protracted weakness, however, could tell of a different story...

Eric Utley
Option Investor

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