Small Cap Banks: The Final Frontier for Bears

Includes: KBE, XLF
by: Thomas MacLeod

If you have been following the banking ETF KBE you may be thinking that the banking sector as a whole is in the midst of a bull trend. On the surface you would be right.

However if you pause and look at the performance of the S&P 500 Bank Index along with the S&P 600 Bank Index, which is a much broader view of the market, the story is somewhat different.

Looking at the charts below, we can see that the small cap side of banking has yet to show any meaningful technical breakout. When we see divergence of behaviour between the small cap and large cap stocks of any particular sector, we start to look more closely as we believe that problems in a market tend to show up first in the riskier small caps.

S&P 500 Bank Index

S&P 600 Bank Index

We do think that the S&P 600 bank index will break out above 250. Why? The homebuilder and morgtage finance sectors suffered terribly under the force of the recent economic downturn and the banking sector in turn. If we review the index MFX, we can see what looks like a bottoming process and a slightly upward curve.

KBW Mortgage Finance Index

We can all find a zillion reasons as to why the banking, homebuilding, mortgage finance and REIT sectors will be in the doldrums for a long period. However the market is telling a decidedly more upbeat story.

Successful trading involves seeking the best risk/reward ratios for your own circumstance. We are contrarian traders at heart and are comfortable allocating a portion of our funds to long term high risk positions. This often takes considerable nerve and sometimes sheer bloodymindedness.

We take some heart from Napoleon's words:

The torment of precautions often exceeds the dangers to be avoided. It is sometimes better to abandon one's self to destiny.

Contrarian traders such as we have already taken our positions and accept the consequences.

Disclosure: Long XLF & XHB Call Options