Trader’s Narrative

One of the signs of the tech bubble was how Information Technology as a sector ballooned from less than 6% (in 1989) to 29.18% (in 1999) in relation to the S&P 500 capitalization. Turning that idea on its head, let’s take a look at the financial sector during the past few years as a ratio of the general market.

As a caveat, let me reiterate that bull and bear markets within the financial sector don’t correspond to the general market: Does a bull market need financial stocks leadership? While at first it may be counter-intuitive, the data backs up the conclusion as you can see from the link.

But nevertheless, following the weight of sectors within the total market capitalization can help us in getting oriented. So I looked at the Standard & Poor’s Financials sector which includes the following sub-sectors (and more):

• Banks
• Consumer Finance
• Diversified Financial Services
• Real Estate Investment Trusts
• Insurance Brokers
• Life & Health Insurance
• Multi-line Insurance
• Property & Casualty Insurance

Here is the annual weight of the financial sector and the banking sub-sector relative to the S&P 500 capitalization (the charts below are interactive so mouse over for details). I was surprised to see that the financial sector topped out in 2006 at a whopping 22.27% of the total value of the S&P 500 index. That’s almost 3 times what it was in 1990:

Zooming in, we can see the monthly weight of the financial sector as a percentage of the total S&P 500 index capitalization from the start of the most recent bear market:

At the extreme low, set in early March 2009 just as the rest of the market was making its recent low, the financial sector reached a critical level it hadn’t seen since 1990! Since then it has jumped to 12.6% as the financial sector has lead the recovery in the general stock market. While no one knows if this is the definitive bottom for the banks, we can say that the March lows were a major low where the sector was as unloved as it has been for the past 20 years.

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While this bear is busy mauling everything in its path, there are some pockets of strength. One of them is right under our very noses: the Nasdaq composite index.

The individual charts of the Nasdaq composite and the S&P 500 Index, each show a crushing bear market. But the relative chart shows that out of the two, the Nasdaq is surprisingly strong.

Going as far back as 2006, Nasdaq’s relative strength has been putting in higher highs and higher lows.

But before we can get excited, the ratio of the Nasdaq to the S&P 500 ratio has to break 1.90 - that’s because since 2004, it has been in a holding pattern below that level. The last time it broke through was in early 1999, and you know the rest of that story.

Financial Sector
Of course, the sector that has everyone’s attention is the financials: banking, investment houses and brokerages. Although technically, a bull market doesn’t need the financial stocks leadership, this market has been primarily driven by the bank stocks because they have been the protagonists in this tragedy (or farce, depending on your point of view).

Today, the financials make up only about 10% of the S&P 500 index. So in a twisted sense, this sector has fallen so much that from here on in, it has much less weight to influence the general index. And that might be a good thing because while it may take decades for the US banks to come out from under the shadow of government intervention into some semblance of normalcy, the rest of the market can push forward.

The financial sector has been beaten to a pulp during this latest bear market. Every time it gets extremely oversold, it manages a feeble bounce only to dive down headfirst once again.

During the past 12 months or so the bullish percent index has jolted from one extreme to the other. According to the bullish percent index for the sector, it looks like we are setting up for one of these bounces:

If we zoom into the chart we can see things a little bit better:

And here is a corresponding chart of the Philadelphia Banking Index (BKX):

This bear market has been unusual because the financial sector has been one of the key players. In previous bear markets the banking sector has actually outperformed the general market. But obviously not only have they failed to keep up with the market lately, they have been the reason why it is dropping like a rock.

Back in May I wrote : Weak Financial Stocks May Not Hold Support Again which turned out to be right on the money.

A bit later in June I wrote that banks where broken:

…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…

The Philadelphia Banking Index (BKX) did indeed fall to 65 or thereabouts - if you interpret that liberally. In fact, the index broke 50 but when the global financial marketplace is melting before our eyes, why quibble over a few points? And the bullish percent did in fact spike to extreme oversold levels, reaching 5.62% in mid July.

These are the buy points that I’ve repeatedly mentioned and explained in how to use bullish percent to time the market. But to give you an idea of how rare this is, here is a long term chart:

Of course, what happened next is that the US government (along with a few others) decided to poke its finger in the crack of the dam and made it illegal to short sell financial stocks until October 2nd. The result of this blatant government meddling in financial markets was the two day rocket ride higher last week. To see this clearer, here is the same chart as above, zoomed in for the year to date:

Aside from the fact that whenever you get the government involved in the market it throws all technical analysis out of whack, the important thing is that before the financial stocks rallied, they had only fallen to 30% in the bullish percent index. Based on this, I suspect that had the government not banned short selling and placed a temporary, artificial floor below them, the sector would have continued to fall dramatically.

Finally, the consequence is that having meddled, the sector is now at 80% bullish percent! Which makes me queasy to even contemplate taking any new long positions. If anything, this is the sort of thin air levels at which traders start looking around for shorts. But of course, now we can’t. This is a royal mess. We’ve gone from a situation which could be analyzed to one which is totally news driven.

Paulson’s Bailout
Here’s the problem that I and many others have with the proposed bailout plan:

• the firms who are at fault face no consequences and do not give up anything
• in fact, the firms are being rescued by ordinary taxpayers who wouldn’t know a CDO if it hit them in the face
• Paulson has dictatorial power and authority for any decisions he makes
• the management who ran their companies in the ground face no consequences
• alternative plans were not presented nor considered
• there are much much better alternative plans

Raise Your Voice
Democrats have begun to push back against the scheme and I doubt that it will go ahead as presented. You can find a lot more articles about what is going on with the bailout and keep up to date by checking: news.tradersnarrative.com

I’m a Canadian so I can’t call up my representative in congress to give them an earful. But the vast majority of my readers are American so I urge you to educate yourself about what is happening. Once you realize the facts, you will understand why it is imperative that you raise your voice against the proposed bailout plan. This goes beyond partisan politics or the election. This is about the economic health of the US and the world. Do this for yourself and your children.

Depending on the framework you use to understand the market, at times it is possible for the market to be “confused” or even “wrong”. Of course, according to some, the market is the perfect amalgam of all relevant information so that isn’t possible.

But then again, any student of the financial markets can easily call up many examples where the market exhibited what can perhaps be best described as collective temporary insanity.

As I look across this market, checking the advance decline breadth, the highs and lows, the VIX, put call ratios, and all the other technical indicators, I can’t shake the feeling that it is a bit confused. Or perhaps, it just can’t make up its mind and is trying to hedge its bets as best as possible.

Just look at the past few trading days! Up, down, up, down, up, down… ending up at pretty much the same place we started.

I’ve been accused of having a penchant for the bullish side so I’m trying to be more than careful in scrutinizing the weight of the evidence, on both sides. And for the most part, there is really no compelling reason to be in either camp right now.

Maybe (gasp) the retail investors are right and cash is the best spot right now.

The market certainly feels heavy, but while intuitively I think it wants to go down, I don’t see any strong reasons to push it down with my own measly contributions.

Here is a snapshot of the sort of thing I mean. This chart shows the percentage of S&P 500 stocks trading above their 10 day moving average. Notice how in mid July, as the market was pulled sharply lower, this very reliable indicator (check out the research report from Lowry’s), did not perform its usual magic:

Is it too much of an obvious to say that this market is being driven by the financials? They were responsible for the mid July spike down in the behemoth S&P 500 Index. Pull up a chart of the 90 day Treasury Bill and you can see the epicenter of the quake that shook the markets.

I’ll go more in depth in tomorrow’s weekly sentiment overview and we’ll see if we can make any sense out of this crazy tape.