Perhaps the biggest market shift in several years is here.
Pundits are out there squabbling whether the latest stock rally has legs. Respectfully, they’re missing the bigger picture.
The Fed is done raising rates.
Those six powerful words mean relief for stocks is near. And the shift has already begun.
There’s one sector of the market that stands to benefit most from the conditions we’re seeing today. I think you should bet on it today, and I’ll tell you exactly what it is.
But let’s first review last week’s unforgettable rotation, which led to what I’m seeing right now.
Yields Crash And Stocks Soar
The stock market’s Achilles’ heel has been soaring interest rates. Since the Fed began its hiking spree in 2022, most stocks have sputtered.
However, when rates retreat like they are now, stocks explode higher.
Last week in particular was monumental. Not only did the 10-year fall 7% peak-to-trough, but it broke below one of the most followed technical indicators, the 50-day moving average.
The 10-year yield peaked at 4.99% on Oct. 19 and fell to 4.52% on Nov. 3. That’s nearly a 50-basis-point repricing.
Source: FactSet
Given that rising interest rates act like gravity on stocks, it only makes sense that equities rebound when yields crash.
And boy have they. The S&P 500 climbed a mind-numbing 5.85% last week. That’s the best weekly return all year.
But that performance pales in comparison to other areas of the market:
- The Financials Select Sector Fund ETF (XLF) bounced 7.41%. This ETF holds a basket of banks, insurers, capital markets firms, and financial services players.
- The small-cap barometer Russell 2000 Index (IWM) surged 7.59%
- Shunned regional banks (KRE) catapulted 12.22%, more than doubling the S&P
When rates dump, just about all stocks bump. But right now, financials and small-caps are leading the pack.
Source: FactSet, TradeSmith
You may be wondering why financials and regional banks in particular bounced so heavily.
If you recall, a couple of months ago, I laid out a data-driven case that financials pop the most when the final Fed hike is in.
Folks, professional investors are wagering on a string of rate cuts next year. This is a major pivot from just weeks earlier.
As shown in the chart below, data from the CME FedWatch tool shows investors expect the first rate cut to come in May. That’s followed by the forecasts of another cut in July, one in September, and one more in December:
Falling interest rates is good news for the Financial sector. As I wrote back in September, this can mean:
- More deal flow — Banks can benefit from more deal flow as rates are expected to fall. According to Axios, 2022 was the worst year for the IPO market since 1990.
- Yield curve steepening — As longer-duration rates climb relative to the shorter end, borrowing short to lend long begins to make more economic sense.
- Private equity (PE) resurgence — Lower rates on the horizon should increase the lending appetite of PE firms.
- Mortgage underwriting — As rates go higher, new mortgages become less attractive. Lower mortgage rates will spur home-buying demand.
And it’s not only these logical benefits that should solely influence the decision to bet on financials.
History proves that the Financial sector is the best performer once the final rate hike is in.
Since 1994, once the Fed is done, this group soars an average of 30% 12 months later:
When you put the evidence together, making a bet on financial stocks right now is smart.
Yields are falling and the pros are betting the Fed is done.
The major shift has already started, with banks leading the cavalry charge.
But how can you make the most of this move?
The obvious way to play this trend is to buy financial stocks. And the easiest way to do that is to buy a basket of them with the Financial Select Sector ETF (XLF).
Regards,
Lucas Downey,
Contributing Editor, TradeSmith Daily
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Source: TradeSmith