Breaking Down the Financial Sector Post-Lehman

For most of 2008, the three sectors I have been watching most closely to gauge the health of the economy are financials (XLF), homebuilders (XHB), and consumer discretionary stocks (XLY). I have even referred to these sectors as my ‘indicator species’ sectors, as I am of the opinion that unless all three of these sectors are healthy, the health of the broader economy cannot be assured.

In the past two weeks, relative strength all three of the above sectors has helped the broader market indices put in what is no less than a provisional bottom. Financials have been the most consistently strong sector, with the XLF financial ETF now 35% above its November 21^st low.

In the chart below, I have attempted to break out the relative performance of various financial sectors over the past three months, using four ETF from the financial sector specialist Keefe, Bruyette & Woods (KBW). The chart dates back to September 5^th, ten days before the Lehman Brothers bankruptcy. The baseline ETF (black line) is KBE, which tracks the KBW bank index. The top performer among the other three ETFs is KRE, the KBW regional banking index. The two laggards are KIE (KBW insurance index) and bottom-dweller KCE (KBW capital markets index.)

In relative terms, insurance and capital markets seem to have enjoyed the more impressive bounce off of the November low. Regional banks, which actually showed small gains in September, have been acting more sluggish as of late. More dominoes are certain to topple as the ripple of the financial crisis continues to broaden its reach, but the recent relative strength in insurers and investment banks bodes well for the financial sector, which just might provide leadership when the next bull leg commences.

[source: BigCharts]