Financials: The Market’s Most Volatile Sector

In our last post, we discussed the correlation (or lack thereof) of various sectors and industries and the overall stock market.  As a result of the post, I received a lot of good feedback as far as how to investigate further these relationships.

One of these suggestions comes from my friend, Patrick O’Shaughnessy.  Patrick suggested that it may be revealing to observe upside and downside capture for the various sectors and industries (FYI – good primer on how to do that here).  Here are the results (1974-2015):

I found it quite astonishing that of the various industries studied (data here), both financials and banks would have not just superior results when the S&P 500 was rising, but also dramatically worse results when it was tanking.  Basically, over the period studied, financials and banks gave investors leveraged returns over the market.  It was a nice ride on the way up, but a harrowing experience on the way down.  Perhaps this is best illustrated by the fact that financials are along among the major market sectors to be significantly below their October 2007 peak (from JP Morgan as of 3/31/16):


It is no coincidence that they are also the highest-beta sector relative to the S&P 500 (1.42, or 42% more volatile than the S&P 500).  To demonstrate this graphically, I looked at 5-year rolling excess returns for both financials and banks (1974-2015):

Financials: The Market's Most Volatile Sector

And for banks:

Financials: The Market's Most Volatile Sector

The graphs show that financials and banks suffered two pretty dramatic declines over the period 1974-2015:  first, the savings & loan crisis of the late 1980s and early 1990s, and the financial crisis of 2007-2009.  There are no shortage of explanations as to why financials and banks soared and then plunged:  a relaxation of some regulations; a secular decline in interest rates; the Fed shifting from targeting the money supply to the price of money, etc.  Whatever the case may be, it seems to be the case that financials can supercharge a portfolio when leverage is easy; conversely, they can blow a hole in your portfolio when the tide turns.  As Oaktree’s Howard Marks is famous for saying, “Leverage + Volatility = Dynamite.”

This is not to say that investors should have no exposure to financials.  It is just to suggest that they do their homework on what exactly they own.  What is important for investors to understand, however, is that in the US, the financial and banking sectors, while important, are not the lifeblood of the market and the economy as they are in many other places around the world.  As we observed in March, the US market is dynamic in the sense that in some periods, financials may lead, and, in others, energy will lead, etc.  However, because markets not of the Anglo-Saxon variety depend more on bank lending for financing and less on what Michael Milken called ‘democratized capital,’ (think equities, junk bonds, etc), crushing declines in their financial sector can hold their entire market hostage.  It is one reason why the financial-heavy MSCI EAFE Index is still well below not just where it was in 2007, but also in 2000: