Warning: Financials Flashing Yellow

In early January, I shared my views that the rally was ending, a timely call. I had noticed, among other factors, that Financials were diverging dramatically. I have been seeing a similar type of action over the past few days that concerns me. The good news is that I don't think that my conclusion is that the rally is ending but rather that it needs to correct. I am still sticking to my views that we are in a range of 730-750 on the downside to 860-920 (880 single estimate) on the upside for the S&P 500. I wish I were confident about whether we are going to establish the top or the bottom first. I believe the bottom, but the resilience of the market leaves me with low conviction. It would be healthier to establish the bottom first.

Before going on, I believe that Financials are an extremely important indicator at this time. While I don't think that they need to lead, they need to be advancing in line with the rally rather than lagging. While this chart of the Sector SPDR Financials (XLF) is very short-term in nature (click to enlarge), I believe that it gives some insight into the near-term direction of stocks:

A few observations:

• Unlike the November Rally, XLF finally broke the 50dma
• Since the 3/19 gap up/reversal, XLF has lagged the rallying market
• Lower panel shows the longer-term perspective of XLF still lagging market

The market has advanced to new rally highs over the past few days, but Financials have been stuck since 3/19. The stall in Financials concerns me, and I expect that if they weaken, the rest of the market will take the cue. Support for XLF is at 8.50 (the 50dma that proved to be so elusive as resistance from mid-September through mid-March. Below that is the January lows of 8. I don't expect that their weakness indicates that the rally is over, but I do think that they could be signalling a correction in the coming days.

Disclosure: No position in any stock mentioned in this report, though I am long an inverse ETF related to XLF

Comments

[jeandit75:]

Another way to put it is keep buying the dip on financials for now because news have been horrible lately, yet stocks are up. Sometimes, investors must be able to take a step back and reassess their views on the market. I understand that banks will go through a terrible loan contraction but the market has already discounted a lot of that. So, since nobody can really predict the future, just pay attention to the recnt weeks action. I personally will be buying the dips.

Apr 08 04:43 PM

[arlin:]

XLF looks like an inverted head and shoulder pattern with the target around 14......it can pull back into the mid 8 area and still be valid.

Apr 09 09:13 AM

[dino33ca:]

Mr. Brochstein, have you changed your view of the banking sector indicators after the quarter results of Well Fargo? Thanks for the interesting article.

Apr 09 01:21 PM

[AndrewBaker:]

This is crazy: Wells Fargo says something nice and the whole world buys the banks! Optimism is good, but foolish optimistic bank buying is one very good way of losing money. I've got my short leveraged financials ETF now tucked away for Easter, so here is my interest declared, but I won't declare how much profit I make early next week (if not later today).

Apr 09 01:51 PM

[Alan Brochs...:]

Well, the timing of this article ranks up there, doesn't it? I was looking for evidence of the rally petering out, and I thought I had found it. When XLF started breaking down yesterday (touching 9.0), I thought I had nailed it. The close, though, sure made me scratch my head, as it rallied all the way back to 9.20 - no-man's land in my view.

Today's action took away my premise completely. While I continue to think that the market is overdone, I can't point to anything tangible suggesting that it is rolling over. I have been sharing an expectation of a "860-920" top of the range for some time now, and we aren't that far.

While I am not fundamentally impressed by the news out of WFC, I am sure impressed by the reaction. Next week we will see GS and JPM report, among others, so maybe we'll get a clearer picture. Since WFC didn't release data or host a call, it is difficult to analyze the massive "beat". Remember, though, management has a lot of discretion in how they report earnings when it comes to banks.

Arlin, I agree with your technical assessment, though it could fall below 8 and still ultimately work. I'll be surprised if we march up to 14 on this run, but maybe later this quarter in a very bullish scenario (maybe).

Apr 09 07:30 PM

[arlin:]

Alan
Interestingly I had been looking at the charts of XLF,and RKH for the last few weeks,thinking that if a move was going to happen,it had to be soon...........both charts were inverted head and shoulders.
To be honest so many of these patterns have failed in this market.
RKH was a monster yesterday.

Apr 10 08:39 AM

[Conan the B...:]

Arlin: thanks for your XLF comment. Targets for FAS are hard to come by because its existence is so short.

If you had not decided to follow, I wouldn't have noticed the H&S bottom.

like I said, thanks.

Apr 10 09:09 AM

[Conan the B...:]

Arlin: 13-14 looks good for XLF, noticed something else. If it were to stall up there for a while, and then close Thursday's Up Gap.

That would potentially set up a larger version of what is taking place.

I was hoping for $20 on FAS, I guess I'll have to settle for $15-16.

Apr 10 09:57 AM