Financials Flash a Warning Signal

The bellwether financial sector (XLF) has not participated in the broad market's 3-day rebound this week. Today, under pressure from subprime losses and downgrades, the group is extending its decline. The XLF was a valuable leading indicator for the broad market in 2007, and may be sending a warning to investors once again.

Last year the XLF completed a "double top" on June 1, and was already down 5% when the broad market peaked in mid-October. The XLF offered an unambiguous turnaround signal on Jan 22, the S&P 500 (SPY) followed one day later. By Jan 24, the XLF was up 10.9% over 3 sessions. The S&P 500 lagged behind with a modest 2.0% gain.

Now the market sees a bullish "higher low" formed by the S&P last week. However, the momentum at the XLF has been negative since Feb 1. The XLF was down 0.6% yesterday and has declined 8.6% in less than 9 sessions.

UBS (UBS) is the latest big bank to remind us that the subprime mess will not go away. UBS reported $13.7B in Q4 subprime losses. The bank has $27.6B of subprime exposure as of December and sees difficult 2008 ahead.

Yesterday, Dow Jones reports that auction-rate securities [ARS] are beginning to fail. This $300 to $350 billion market depends on past liquidity levels to fund auction-rate resets every 35 days. There are now too few buyers at these auctions and many corporate treasurers are now getting stuck with an asset that was once considered a safe place for short-term money.

In the Wall Street Journal's "Heard on the Street" column, the writers reviewed old fears that off balance sheet structured investment vehicles [SIV] may need to return to the parent banks' books due to backstop provisions. Such a move would tie up precious capital at the banks and reduce lending.

Now earnings estimates for the big investment banks are coming down. Deutsche Bank (DB) cut its Q1 EPS estimate for Goldman Sachs (GS) to $2.63 from $4.64. The Reuters consensus Q1 EPS estimates for Lehman (LEH), Bear Stearns (BSC), Goldman (GS), Morgan Stanley (MS) and Merrill Lynch (MER) have declined by 24.5%, 35.0%, 20.9%, 19% and 48.9% respectively over just the last 90 days. (BSC, GS, LEH and MS report Q1 earnings in mid-March.)

The AMEX broker dealer index was down 0.6% yesterday and 8.7% since Feb 1. The KBW Bank Index also down 0.6% yesterday, and has declined 8.4% since Feb 1.

Other key market indicators including semiconductors (SOX-1.1%) and retailers (RLX -1.4%) were also lower in yesterday's trading. Meanwhile, interest rates are going up for long treasuries. The 10-yr bond is yielding 3.79%, up 32bp from January 22, while the 30-yr yield is at 4.60%, up 42bp from January 22.

Disclosure: none

Comments

[Reinko]

All that off balance crap will go back to the 'official' balances because next year there will be the Basel 2 system of measuring commercial bank reserves anyway.

At present off balance items do not count in the bank reserves and to make it all the more better; according to the Federal Reserve h3 release combined on balance reserves are in the negative.

To be precise: 18009 miilion US$ in the red, go to the next link and look in the column 'non borrowed (3)':

www.federalreserve.gov.../