Financial-service shares swing lot of weight in equity markets

The Insider

Your Money

May 16, 2004|By BILL BARNHART

CONFUSION abounds over the apparent unwillingness of the stock market to reward investors at a time of great promise in the economy.

Conventional wisdom points to fears of inflation and higher rates as the culprits.

Expanding on that theme, the dominance of financial-service stocks in global stock markets appears to confirm beliefs that money-lending issues are driving equity values.

Investors need to understand bankers.

Financial-service companies, notably banking giants, hold considerable sway over stock-market indicators, such as the Standard & Poor's 500 index.

Financial-service stocks make up the largest of 10 major sectors in the S&P 500 index and account for more than 20 percent of the market capitalization of the index. That's well above their normal weight of about 15 percent, according to the Leuthold Group.

Banks hold a 22 percent stake, the No. 1 rank, among 12 industry groups in the Russell 2000 index of small-company stocks.

The dominant weight of financial-service stocks is even greater outside the United States.

Banks and brokerages represent 27 percent of stock market value outside the United States, compared with 13 percent for technology and telecommunications, according to the Dow Jones World Index.

Bank stocks matter. And they are convenient fall guys when rates rise.

The current rate scare began April 2, when the strong March payroll report shocked traders.

Financial stocks promptly pulled the market lower, with losses in that sector exceeded only by the much smaller materials and utilities sectors.

This reaction is a classic knee-jerk market move, says veteran bank-stock watcher James K. Schmidt of the John Hancock Financial Industries Fund.

"Over time, the relationship between the relative performance of financials and interest rates is not very tight. Most people way overstate it," he said.

"When [Federal Reserve chief Alan] Greenspan is on TV and says something implying rates will move higher, sure enough, the bank stocks go down. But if you measure over the next six months, that effect disappears."

One reason is that banks have improved their ability to match the cost of their liabilities, including deposits, and the income from their assets, including loans, Schmidt said. Banks today are less interest-sensitive than 20 years ago, Schmidt says.

Moreover, in the early stages of an interest-rate uptrend, banks often boost profit margins by keeping deposit rates sticky while raising loan rates.

Financial-service stocks have other problems. Bank stocks typically lag during a strong economic rebound.

Bankers' relationships with corrupt companies have eroded the industry's reputation and magnified its exposure to regulatory and private litigation.

Bankers have won praise from Greenspan for skillfully managing their balance sheets through several economic crises in recent years.

But they've done it largely by outsourcing their business risks to speculators. Inadequate saving by Americans increases the vulnerability of banks, especially U.S. banks.

If financial-service stocks push the market lower, don't blame interest rates alone.

Bill Barnhart is a financial columnist for the Chicago Tribune, a Tribune Publishing newspaper. E-mail him at yourmoney@tribune.com.

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