Can Banks Stocks Show What's Next for Dow 14,000?

History shows that bank shares are reliable indicators of what’s next for the economy.

In this photo from Dec. 19, 2012, people walk past a Bank of America branch in Philadelphia.
By SHARE

The banking industry's credibility sank so low after the collapse of 2008 that there were doubts it could ever again be the trusted provider of credit in the U.S. economy. In one sense, though, the banks have been telling it straight all along—via stock prices that really tell the story about where the U.S. economy is heading.

In two of the most important stock moves in recent history, bank shares have been reliable indicators of what's next. Here's how: The Standard & Poor's bank stock index started falling in early 2007, sending a clear warning of falling credit quality more than a year before the 2008 financial market collapse.

Those same bank stocks also foreshadowed the rally that propelled stocks to a five-year high in January, when equities had their best monthly start to any year since 1967.

While the first month usually sets the tone for the year, it remains to be seen whether this rally has staying power. One place to watch for an early indicator could again be the banking sector, which has been providing the signal for the market's moves as the financial sector has gone through its most difficult period since the Great Depression.

[Read: Is It Time To Buy This Rally?]

"The leadership of the banking stocks is absolutely imperative, and it's been proven multiple times," says Art Hogan, managing director of Lazard Capital Markets. "You have to keep watching the sector now to see how they fare going forward."

The finance sector as a whole is often hard to read because the high rollers and risk takers in the space create a lot of noise and volatility. One way to cut through it is to watch either the relatively low-beta Standard & Poor's Banks Select Index, and the SPDR S&P Bank ETF, an exchange-traded fund that tracks the S&P banking index, or the KBW Bank Index, which that ETF tracked during the crisis (it switched to the S&P version in 2011). Using the KBW index as a filter, you would have seen a sector quietly shedding one-third of its value in an orderly downhill move that lasted through all of 2007.

The SPDR ETF went through that descent without ever experiencing the volatile ups and downs of investment banks at the time. As it fell, Goldman Sachs and other large investing houses continued higher in 2007, buoyed by trading profits and cheered by bullish calls by their executives right up until the crisis began to unfold.

Bear Stearns, the first major firm to require a government-assisted bailout, was trading near all-time highs in early 2008 until $30 billion in losses turned up and its stock dropped 84 percent in a single day in March 2008. Goldman, as well, tumbled in a series of dramatic one-day declines.

[Read: Don't Fight the Central Bank Rally.]

Fast-forward to 2012 and, without much fanfare, the S&P banks have booked a steady rise of just over 20 percent since last August while the Dow was about to go into a steep 1,000-point decline in September. The KBW index includes some big names—among them Bank of America and Citigroup—but most of its 40 components are lesser-known regional banking powers such as Comerica, SunTrust, and PNC. These major lenders to Main Street businesses and retail customers operate financial niche businesses on a national level, but they avoid the notoriety that comes with Wall Street investment banks' high-stakes deals, mega-bonuses, and the trading scandals that seem to continually follow them.

"The finance sector is meant to be the conduit of the story—and they are not supposed to become the story themselves," says Hogan. "Since the downturn, they have been getting back to the basics and cleaning up their balance sheets. And they are in better shape now."

In the post-collapse era, regulators have pushed banks to shed risky business and focus on the basics of business lending and mortgage operations. The recent rise in the KBW index reflects the ability of commercial banks to grow the bread-and-butter lending activities that have been their traditional strengths. The Wells Fargo/Gallup Small Business Index of credit availability reached its highest level in three years last summer in an early sign that lending was on the rise. At the same time, housing prices rose 5.5 percent through November last year and consumer confidence hit a four-year high.