The Financial Sector SPDR (symbol XLF) is an exchange-traded fund that tracks the performance of the S&P's financial sector index. This index is comprised of 84 financial services companies, with the heaviest weightings in commercial banks (29%), insurance companies (21%), capital markets (18%) and thrifts/mortgage finance (9%).

The top ten holdings comprise just over half of the value of the fund (50.7%). The largest holding is banking and brokerage giant Citigroup (C, $45.65, 11.4%), followed by leading insurance player American International Group (AIG, $70.80, 8.9%) and national banking powerhouse Bank of America (BAC, $80.20, 7.9%). Four of the fund's five largest holdings are commercial banks (although Citigroup and Bank of America have considerable brokerage and investment banking businesses), with banks and brokerages accounting for eight of the ten largest companies.

Although many of these firm are considered to be interest rate sensitive, XLF's correlation to the bond market is actually negative (much like the rest of the stock market). Note that historically, correlations between stocks and bonds have moved back and forth between positive and negative. The increasing ease of shifting funds into and out of various asset classes has apparently changed this behavior, as money now flows much more quickly into the investment class where near-term profits appear most likely. Therefore, stocks in the financial sector have a lower correlation to the bond market now than they did in the past.

Many of XLF's component stocks pay quarterly dividends. Based on recent prices and dividends paid in the twelve months ending May 2004, the fund's dividend yield is a respectable +2.0%. This yield can help smooth losses during a market downturn. However, brokerage stocks can be especially volatile during declines due to their low price-to-book ratios.

On the whole, financial stocks outperformed the S&P 500 during the 2000-2003 stock market meltdown, losing only about -40% from top to bottom. After rallying strongly last year, financial issues have fallen considerably in recent months. This should not come as a surprise, as this sector tends to underperform in a rising rate environment. Remember, not only do higher interest rates ultimately slow the economy, but as rates at shorter maturities rise, bank profit margins also tend to decline. After all, banks make their money on the spread between borrowing and lending rates, and the majority of their borrowing comes in the form of short-term liabilities (deposits). Banks perform worst when the yield curve inverts, which tends to happen when Wall Street expects a recession.

As of May 2004, the yield curve was still relatively steep -- rates were much higher for longer maturities than shorter maturities. However, that trend is now changing to a flatter curve, which tends to pressure financial company profit margins.

HOW TO MAKE MONEY IN XLF THIS YEAR
If XLF is going to rally, then now is the time. As I write this, the Financial SPDR is well off its weekly low and may put in a bullish candlestick pattern. Although the fund remains in a bearish weekly MACD crossover, it came within about 3% of the 38.2% retracement of the whole bull market rally. That is a substantial sell-off in just two months. The strong volume last week is bullish as well. Look for XLF to make an attempt to retest its previous highs, although a new high is no guarantee. In addition, my expectation for a bear market later this year means that traders should look to sell this fund short as it approaches its prior highs.

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