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The Bank Index is Telling



Yesterday was pretty wild as the Fed's Open Market Committee policy statement caused quite a stir. The collective wisdom in the investment community was that once the war in Iraq was over and oil prices fell, there would be a significant pickup in economic activity and therefore corporate profit results. The Fed's statement yesterday suggesting that there is risk of further weakness -- and the clear indication the interest rate policy makers are concerned by deflation -- puts that collective wisdom at risk.

The fact is that at the end of the day the market didn't really care what was said. Stocks were strong going into the announcement, dropped just after it, and then rallied back to the earlier levels. If someone bought stocks because of an expected surge in earnings the reason to be long has changed.

Heads up on the BKX

The more important point this morning surrounds the PHLX Bank Stock Index (BKX). There are too many time frames, indicators, and price patterns to look at each day. Due to the extent of the recent gains, I wanted to focus on the weekly price patterns and 14-period stochastic indicator to see how much more the various sectors of the market could move and what happens from extreme overbought levels. As I was going through the various charts, I took special note of the BKX because the index has been in a trading range for the past five years with the stochastic oscillator appearing to give many very good buy and sell signals.

What I found when I started back testing the overbought and oversold signals on the weekly chart, was that the extreme overbought signals were excellent. Many folks look for the SK&SD to cross above the 80 level to generate a sell signal. Since so many now look for the clear signal, I went back to see what happened when the SK (3 period average) got above 80 (extreme overbought) and then 90 (wicked extreme overbought) before any crossing took place.

The results were very compelling. Over the last five years, which included a bubble, a 3-year bear, interest rate hikes and reductions and two wars (Afghanistan and Iraq), 12 out of 15 times the SK hit 80 or above, that was THE peak week for the BKX. Two of the remaining three instances, there was a one-week delay and then a solid downside trade. In only one instance did the above 80 signal not work right away (within a week) and even in that instance the BKX went up 6% over the next three weeks and then fell back by 5% in the following two.

The average decline in the BKX (on a weekly close basis) after the SK reaches 80 or above is 8% in just over three weeks, as this table shows.

The accuracy of the "greater than SK 80 signal is compelling.

The other and more compelling intermediate-term story is that the once the SK reaches over 90, the indication is that there is limited upside in the sector and that a more significant decline is forthcoming.

The BKX is clearly overbought enough to catch attention.

Source: Baseline

This signal doesn't necessarily have to be a broad market-timing signal. It is what it is - a sign that the financials are tired, due for a pull back and may cause the whole market to lose some momentum just as it reaches into the upper end of the range. Treat it as you may, but I believe that the above suggests the "fear of missing" may be just a tad overblown.

Note: As originally published, one column in this table was incorrectly labelled "SPX%."

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