If anything, risk sentiment seems to be back in the market, as explained in What’s The Message Of These 4 Risk Indicators. Now if that holds true, it will be a critical piece of information to investors as it will determine where the biggest gains reside in the coming 6 to 12 months.
One area which will largely benefit from a risk-on sentiment is the financial sector, specifically in the U.S. The underlying rationale is based on “yields”, the ultimate risk indicator: as yields rise, the finance sector is able to be more profitable.
The following chart shows the finance sector in the upper pane (XLF, a sector specific ETF) and 10-Year Yields in the lower pane. Though there is no long term one-on-one correlation, it is clear that their primary trends are correlated. In particular, once yields bottom, the finance sector starts rallying strongly, as evidenced by the developments in the summer of 2012.
As most of our risk indicators are pointing to the return of risk-on investor sentiment, we would expect yields to start rising from here, at least in the short and medium term. In such an environment the finance sector will offer low risk / high reward opportunities to investors.
As a sidenote, the XLF ETF is testing an import resistance area. If XLF breaks out of the triangle shown on the chart, it would represent a strong BUY signal, certainly if yields start rising as well.