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Stock Market Strategy: Financial Sector Flashes Warning / Reduce Risk, Increase Diligence

The end of August ushered in a torrent of Fin. TV commentary about the perils of September. Don’t you remember all the talk about how “September is the worst month of the year”? Now the favorite sound bite of  Fin. TV is how we just experienced the “best September since 1939.” Does this fact have any bearing on the process of making successful investment decisions?  Of course not, but in a classic example of Fin. TV hype this story repeats almost every hour and has for the last couple of days. Now, to add insult onto worthless commentary, talk of  ’October historically stronger than September’ is making the rounds this morning.  

I’m here to put an end to the insanity. Traditional thinking doesn’t get it done in this market.  Fin. TV analysis was dead wrong about September and I’ve no doubt October will surprise as well. In fact, I will take it a step further and say a glaring red flag has popped up on an otherwise pristine bullish landscape.

It has taken a while for me to write this post because I don’t necessarily want to shift my bullish stance. I wrote recently “Follow the Fed!” and we have ridden that bullish mantra well over the last couple of months. However, following another theory that ‘only the paranoid survive’ I feel the importance of recognizing this ugly warning sign cannot be overstated.

Ugly Warning Sign:

 xlfspx

The chart above is an overlay of the financial index as represented by the ETF XLF (Blue line) and the S&P500 (Green line).  You can see, a disturbing divergence has materialized over the last two weeks. As the S&P500 marched higher the Financial stocks moved lower; something’s got to give. Will the Financial stocks catch up in October and drive this rally onward or is the deterioration of the group going to lead to broader market weakness?

I could answer that question by saying Financials have traditionally led the market. However, I argued earlier in this post that tradition no longer holds the cudgel.  So we are at a bit of an impasse. Should the Fed continue Q.E. programs at the current aggressive clip I suspect any weakness caused by the financial sector will be contained.  However, if the Fed’s efforts begin to have diminished returns(perhaps this is the message the Financials are sending) then October could be brutal.

I would note that today’s market response(down across the board) to the Fed’s Permanent Open Market Operation(POMO) was disturbing. Moreover the auction was a disappointment as Zero Hedge explains:

“…only $11.5 billion in higher yielding bonds were submitted to the Fed for repurchase, as it appears Primary Dealers would rather hold on to the best yielding paper currently available than hand it back to Brian Sack. This may have rather unpleasant implications for the Fed which will soon monetize across the curve, as it demonstrates that there is very little monetization interest in the long, and thus higher yielding, end, which in turn will force the Fed to monetize ever more short maturity debt. As a result, the Fed ended up purchasing a paltry $2.2 billion…”

Perhaps today we witnessed the first piece of evidence of the Fed’s diminished strength.

Either way, after a strong September the time has come to recognize the changes and adjust the portfolio accordingly. Reducing risk and taking some of the heady gains off the table would be appropriate.  Meanwhile, the Financial sector malaise must not be ignored. I have compiled a list of articles for your perusal that I trust will shed much needed light on the topic:   

The G-20 will consider even tougher guidelines for biggest banks: They are discussing setting capital requirements 2 to 3 percentage points higher for the worlds biggest banks, in addition to BASEL requirements.

Morgan Stanley Said to Freeze Investment-Bank Hiring for 2010

It’s Really On: JPM Tells CNBC It Is Systematically Reviewing Foreclosures

Foreclosing on mortgages without titles. Mortgage Gate Just Got Weirder: Counterfeit Court Summons

Senator Franken Sends Letter To Bernanke, Bair And Holder Demanding Criminal Charges For All Responsible For Biggest Alleged Mortgage Fraud In History

Are The 250,000 Foreclosure Sales From Q2 About To Be Reversed, As Fitch Prepares To Downgrade Foreclosure Fraud Companies

Positions: Short: JPM, XLF, MS



Disclosure: Positions: Short: JPM, XLF, MS

Disclosure: Short: JPM, XLF, MS