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Why Not to Be Overly Negative on the Financial Sector


That is, in general or on the bank and broker/dealer sectors in particular. Here's why.


Early strength in the US dollar couldn't offset the continued positive momentum in stocks and commodities and a tame inflation outlook in the form of a lower-than-expected CPI report on Friday. The greenback was flying and the euro was collapsing early on Friday morning when big money began exiting what had become a very crowded short the euro trade. That shift in assets led to a rapid short-term decline in the DXY, which in turn fueled further gains in stocks and commodities. For the week, it appeared that the safety trade was replaced by the risk trade (see chart below).

The benchmark 10-year Treasury lost more than 2% last week, as yield moved up to 3.78%. The yield briefly touched 3.82% for the second straight day. Yield is up 24 basis points since February 5, as the 10-year note is stuck in a two-week downtrend. Expect this directional movement to continue, as both up and down moves for the 10-year have tended to last three to five weeks over the last six months. If this pattern continues, we could see rates at 4% in the next one to three weeks. Our play on rising rates has been TBT and my target for the 10-year yield is 4.12%.

Interestingly, stocks began to move higher the same day longer-dated Treasuries began to slide. While the 10-year note is down about 6.5% in price since February 5, the S&P is up just over 6%. If this correlation continues, it seems plausible to think that the S&P could flirt with its recent high of 1150. Downside risk for this index appears to be where the rapidly rising two-week uptrend line comes in -- currently near 1083.

For those willing to take on more risk, commodities have offered even better returns since February 5. The DB Commodity Index Tracking Fund (DBC) is up nearly 10% in that time period -- all while the US Dollar Index (DXY) has remained nearly unchanged. As with the S&P, it's not difficult to imagine the DBC moving up to test its recent high of 25.72. Immediate support would be the two-week uptrend line, which is presently around 23.65 -- about 1.25% below Friday's closing price.

The currency markets seem to be the main driver of asset prices. When the dollar is weak or flat, bond prices fall and risk assets move higher. I've reported extensively on the importance of the nearby 80.73 level for the DXY. Continue to monitor this key level. A daily close above 80.73 should be harmful to stocks and commodities. Should the Dollar Index move sideways or pull back to its three-month uptrend line (approaching 79), the S&P and DBC are likely to test their recent highs.

This morning Asian markets were strong overnight, with Japan and Hong Kong higher by more than 2% and Australia up nearly that much. European markets have traded on both sides of the flat line and are mostly unchanged. Crude futures are up slightly and flirting with the $80 level, while gold is flat near 1120. The dollar is trading mixed versus a basket of major currencies. This has the DXY flat so far this morning. No big earnings reports due, but Bernanke speaks at 11a.m. and the US Treasury is auctioning T-bills and TIPS today (see below).

Earnings due out today:

Freddie Mac (FRE); Flowserve (FLS); Blackstone Group (BX); Sears Holdings (SHLD); click here for complete rundown of companies reporting earnings, estimates and actual results

Economic reports due out today:
Janet Yellen speaks at 10:30a.m.; Ben Bernanke speaks at 11a.m.; 3-month and 6-month US Treasury Bill auctions at 11:30a.m.; 30-year TIPS auction at 1p.m.; click here for complete rundown of economic releases including actual versus estimated data

Market internals: NYSE
(Figures are rounded)

Key Charts

  • With Bank of America (BAC), JPMorgan (JPM) and Citigroup (C) up an average of nearly 7% since the close on February 12, it's worth examining the technical condition of the bank and broker/dealer indices. I'll use the KBW Banking Index ($BKX.X) and the ARCA Securities Broker/Dealer Index ($XBD.X) for this analysis.

  • The weekly BKX chart displays the strong downtrend in place for the bank group since the 2007 peak. The group bottomed in early March with the rest of the market. That was the culmination of a wave III lower.

  • What ensued was a tremendous rally in the banking sector that I believe is an ABC correction. The move stalled within four pennies (49.24 versus 49.28) of the 61.80% Fibonacci projection line. However, wave C of an ABC correction will typically reach the 100% Fibonacci price projection line -- especially for this type of zigzag correction (see chart).

  • That leaves this index at the proverbial fork in the road.

    • If the BKX can trade and close above 49.24 (call it 50, if you want to be conservative), then the index should be able to trade all the way up to the 59.16 level (the 100% Fibonacci projection price);

    • If the BKX fails here or anywhere under the 49.24 level, then wave C may have already completed and this is really the early to middle stages of the first or third wave of a primary wave lower.

  • Given my recent call that the broader equity indices have completed their upside correction and are in the next wave lower, the latter scenario might seem the better fit.

  • However, it wouldn't be prudent to reach that conclusion prematurely. Recent strength in the bank group should give pause to those anxious to bet against the banks here.

  • A look at the daily chart below will show just how constructive the BKX has been of late. Some of the evidence includes:

    • Trading above both the 100- and 400-day moving averages

    • 100-day MA is now trading above the 400-day MA

    • Just broke out above a one-month downtrend line

    • RSI has also broken a downtrend, confirming the price move

  • As previously mentioned a break above 50 will confirm the bullish action and signal another 15% - 18% of upside potential for the remainder of wave C.

  • The broker/dealer index (XBD) closely resembles the bank index in some respects. For example, the XBD put in a wave III low in March, along with the banks and the S&P.

  • Similarly, it appears the XBD also has more potential upside, with the 100% Fibonacci price projection line just above 134 serving as the target. That level corresponds closely with another key Fibonacci number. Converging Fibonacci levels make the case stronger.

    • 134.13 is the 100% Fibonacci projection price for wave C of the ABC correction

    • 134.60 is the 50% Fibonacci retracement level for the wave III decline that ended in March of 2009

  • Interestingly, the XBD already breached its 61.8% Fibonacci projection line back in October. Since, peaking last fall, the group is currently off 9% -- the banks are down 5% over the same period.

  • Also noteworthy, the broker/dealers have not been quite as strong as their banking brethren. The BKX moved up nearly 177% (currently 163%) off its March '09 bottom, while the XBD rebounded 129% (at its peak last October) and is now 108% off the March '09 low.
Strategy: I wouldn't advise being overly negative on the financial sector in general or the bank and broker/dealer sectors in particular. If you have a negative view on the financials for fundamental or anecdotal reasons, it may be more prudent to go to cash in lieu of selling short the financials. If you're bullish on the financials, then you can take a small or partial position in the XLF, the KBE or the IAI, with the idea of adding to that position on a break above the $50 level for the BKX and the $117 and $120 levels on the XBD.
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No positions in stocks mentioned.

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