Trader’s Narrative

The financial sector, as measured by its proxy, the Philadelphia Banking Index (BKX) has definitely broken down. I said as much before the end of last month. While it seemed that the line everyone was watching (level 75 on the chart) might act as support, it didn’t convince me.

While it put up a bit of a struggle dancing around the line for 3 more trading days, it has now decidedly broken down:

The red line marks when I suggested that the sector would break down. The next support, as you can see, is still some way down. So I would stay away from the long side until it reaches that level.

But the good news is that if or when it does plumb those depths, there is a good chance that it will find significant support. It will be fourth time, after the 1998 LTCM bottom, early 2000 and the late 2002 bear market floor.

There is some technical support level at 70 but before a definitive bottom can be in place this sector may need to get to real support and wash out all the weak hands.

And I suspect that by the time the Bank Index finds its way down to 65 or thereabouts, the bullish percent index will have commensurately fallen to significant buy areas:

That would be, at least, a 20% points drop. Until then, while rumors like those swirling around Lehman Bros. (LEH) may fly and the negative sentiment may get even thicker than it is right now, I doubt that this sector will find its footing.

But while this may be bad news to those long banks, or other financial stocks, I don’t think that it necessarily means the market itself is somehow doomed. A bull market doesn’t need financial stocks.

This week the financial giants Goldman Sachs (GS), Bear Stearns (BSC) and Morgan Stanley (MS) will be releasing their quarterly earnings reports.

I’ve been patient and hopeful with this sector since it has been showing the classic signs of oversold extremes.

But each time it is given a chance to bounce back, it only musters a meager step or two forward… and then falls back.

You can see this in the bullish percent index of the sector:

In July it reached an extreme oversold level of 25% but couldn’t gain any traction. Then again this November the index fell to 20%. But after a feeble “dead-cat” bounce it has rolled over again. This behavior is a marked contrast to the previous years when the bullish percent index remained at very high levels and only sporadically dipped lower.

Looking at the price chart itself (the Philadelphia Banking Index) we see the same thing. A classic downtrend pattern of lower lows (green) and lower highs (red):

No question that things are downright ugly. Within the sector, only 17% of the component stocks are now sitting above their 200 day moving average. This is extreme. But it has been the case for most of the time since the swoon in July. Only 4% closed above their short term, 10 day moving average and a paltry 13% above their 50 day moving average.

But when oversold levels don’t lead to lasting rallies, you know something is wrong. The banks and financial stocks are acting very tired here and I would either wait to see a dramatic washout (the kind that has you gasping) or a miraculous sign of strength before giving them the benefit of the doubt again.

At the end of July I mentioned that it was time to consider the battered financial sector. Back then, the bullish percent chart for the sector approached 25%, a level which usually means oversold. But yesterday, this same indicator dipped to just 16.13%:

After I mentioned the opportunity to go long the sector, banks and financials did recover but in a very limited way. Even so, the paltry rally was enough to push the bullish percent index to almost 80% - which was a sign that things had swung to the other extreme and it was time to exit.

Getting back to the present, the bullish percent index has not been this low since early 2000 - when the Philadelphia Banking Index (BKX) was more than 30% lower:

Things are very stretched to the downside here and we are ripe for a snap-back rally. Although it is extremely difficult, the best time to buy a bargain is when everyone else is running for the hills, screaming in fear.

See this link to learn more about how I time the stock market using bullish percent charts (based on point and figure charting).

Looking over the bullish percent indices for different sectors and markets, I noticed that the lowest reading is from the financial sector. Check out my previous post for more information on how I use bullish percent indices to time the market.

The riddle of the financial sector seems to have been solved! What it was trying to tell us apparently is that the market didn’t have the leadership needed to sustain its new highs.

But the hammering it has gotten lately has put the sector at the threshold of giving us a bullish percent buy signal. As the chart shows (below), the bullish percent index fell last week to 30. The financials haven’t seen such a low reading since the 2002 bear market bottom!

I’d prefer a reading in the 20’s but even at this point, we are arguably in the “buy” zone. Looking at the Bank Index (BKX) we see that it could fall to support in the low 100’s range. The next line in the sand would be 95 which would surely put the bullish percent index into the low 20’s.

The question is, is the nature of the market changing? If it is, then we could go lower as a new bear market takes hold. If this is yet another correction within an ongoing secular bull market, then we are close to an inflection point for the financials.

Of course, if the Fed wakes up and cuts the interest rate as the bond market has been screaming at it to, then this sector would rocket higher.

I’d suggest even without that, the financial sector presents a compelling case here. Take a look at the usual suspects: Citigroup (C), Goldman Sachs (GS), etc.