Trader’s Narrative

The financial stocks are not doing too well right now. I’m just telling you in case you’ve been hiding under a rock or have been floating in sensory deprivation tank for the last whee bit.

It seems everyone is looking at the poor financials and noting how weak they are relative to the market. The shibboleth is then trotted out that we need the financial stocks for a healthy bull market. I’m sure you’ve heard or read this multiple times.

I caught myself repeating it in my previous post (see above link). But rather than accept it at face value, lets put it to the test.

Does a bull market truly need the leadership or participation of the financial sector?

To begin, here is the chart of the Philadelphia Banking Index (BKX) compared to the S&P 500 Index (SPX):

Remember, this is a relative chart. When the financial sector is doing better than the general stock market, the line trends up, and when they are weaker than the general market, the line goes down. And while the ratio showed incredible volatility between 1998 - 2003, the BKX was relatively unchanged, simply treading water the whole time.

Now lets see how the market actually behaved during the times that the financial stocks were leading and during the times that they were weak:

The bull market didn’t start in 1995 but it certainly did intensify with a sharp upturn in its slope. While the S&P 500 continued to rally - with intermittent corrections - until 2000, the Philadelphia Banking Index (BKX) only kept up its leadership till early 1998.

From then to the S&P 500 market top (otherwise referred to as the “bubble top”) financial stocks actually performed weaker than the general market. It certainly didn’t faze the bull market though.

Bull or Bear, Banks Don’t Care
As the tone changed and a bear market took hold, the financial stocks re-awakened and took leadership once again. They actually performed better than the S&P 500 as the bear market raged on. In retrospect, they were a decent hiding place. You didn’t make much money on an absolute level but you didn’t lose money either. If you had borrowed a tactic from a hedge fund playbook, I suppose you could have made money going long financial and short the S&P 500.

Finally, as the bear market subsided and a new bull market was born, the financial sector lost its luster and started to underperform again. Little at first but more recently, at a torrid pace.

I know this is a short slice of market history but even from such cursory analysis it seems that there isn’t much stock in the common belief that financial stocks need to lead a rally. Nor that they need to perform better than the general market for us to enjoy a bull market. In fact, there is no real relationship that I can discern. If you see one, please edumacate me.

I believe there are conditions that precede bull markets - this just isn’t one of them.

Sacred cows make the best burgers and this one is of kobe proportions. If your blood-lust is not satiated, let the intellectual slaughter continue by checking out how cumulative breadth can be misleading.

Financial stocks have been the favorite punching bag of the shorts. And no expletive does the price action justice, especially if you’ve been long any of them as I have.

The problem is that no level of oversold seems to bring in enough strong hands to give it a reprieve. It seems that ever little bounce is just another chance for the shorts to pile on.

Things have gotten so bad that only 15.22% of the stocks in the sector have buy formations according to point and figure charting (as of yesterday’s close). To find things in similar disarray, we’d have to go back to early 2000 (14%) and late 1998 (11%).

Obviously, both of those were great buy points.

What gives more impetus to the argument now is that the banks and brokers are not the only stocks that are extremely oversold according to (bullish percent charts). Pretty much everything is - with the exception of energy. In fact, the last time the bullish percent indices for this many sectors were collectively this low was in mid August 2007.

For more information, follow this link to see how I use bullish percent charts to time the market.

So we have everything we need lined up: lackluster sentiment, an unbelieving public, unprecedented and unyielding bullishness from insiders (commercials) and a reprieve from the bond market.

Looks good doesn’t it? Prices are demonstrating the sentiment and technical underpinings by breaking out into thin air territory.

Just one thing that bothers me about the current scenario. If we are indeed on the threshold of a powerful, new bull market… then why are the financials so weak? Of the two, the Bank Index (BKX) is weaker. But the Broker Dealer Index (XBD) isn’t anything to write home about.

Since they are a leveraged proxy for the market, why aren’t they are the forefront of the move?

What I mean by that is each company in this sector has its destiny intertwined with the stock market. The more activity there is, the more money they make. The higher the market goes and the healthier it is, the more money they make. In effect, they are a sort of never expiring call option on the stock market.

So what explains their lackluster performance?

Are banks and brokers simply shunned irrationally? Have they become (saints preserve us) “value” plays? Maybe the market’s wisdom senses some as yet unforseen calamity like the sub-prime debacle. But then again, even Bear Stearns (BSC) seems to have come out almost unscathed. Looking at their stock chart, it is hard to imagine this is a firm going through a major crisis.

Here is the Broker Dealer Index (XBD) which is trying mightily to just hang on, relatively speaking:

And the Banking sector, significantly weaker and in a clear short term downward trend:

Speak of the devil! Interactive Brokers released a message just yesterday (thanks to Kryslon for the heads up in my previous post about the Interactive Brokers IPO). I’m glad to see that IB clients can bid on the initial public offering!

[Letterhead of Interactive Brokers]

Dear Friends of Interactive Brokers:

After 30 years of building our closely held company, we are ready for the next phase of our development. We believe that a public offering of our shares will provide us with greater name recognition and accelerate our growth. Accordingly, we are now launching the Initial Public Offering of 20 million shares of Interactive Brokers Group, Inc. (“IBKR”), and we expect the public offering price to be between $23 and $27 per share.

Throughout our history, we have dedicated ourselves to building technology to provide liquidity and direct market access for our customers at very low costs. It is in this spirit that we are offering our shares in a Dutch auction through WR Hambrecht + Co.’s Open IPOTM system.

IB Account Holders can participate in the IPO through our fully electronic IBIPO Dutch Auction System, or along with others may buy shares in the IPO through the participating broker of their choice. Enclosed you will find a copy of IBKR’s preliminary prospectus as filed with the Securities and Exchange Commission. Complete details on the mechanics of the IBKR IPO are contained in the prospectus’ Plan of Distribution section.

IB Customers will find instructions on how to enter and cancel bids in the IBIPO Auction system at www.interactivebrokers.com/IBIPO. The IBIPO Auction system may be launched in Account Management under the Trading Access/IBIPO Auction tab.

For the latest information on the IBKR IPO, including updates on the list of participating brokers, offering dates and an electronic copy of the prospectus you may visit our dedicated web site IPO.Interactivebrokers.com.

An IBIPO auction is typically open for bids for one to two weeks prior to the closing date of the offering. Once the bidding concludes, WR Hambrecht + Co. will assemble the bids and, working from highest to lowest, it will identify the first bid price that will sell all the offering’s shares. This is the clearing price and will be the maximum price at which the issuing company will offer its shares. The issuing company and placement agents will then decide the price at which the issuing company will offer the shares, taking a number of economic and business factors into account in addition to the clearing price.

As always we greatly value your business and look forward to continuing to serve you with our premier technology and low trading costs.

Sincerely,

Thomas Peterffy

And here is the amended S-1 with the changes in participating dealers.

Interactive Brokers announced their plans to go public on November 27th, 2006 with the filing of an S-1. But since that announcement we’ve heard not a peep out of them.

The founder, Thomas Peterffy, continues to thumb his nose at the sell side firms by planning to use a ‘Dutch auction’ to distribute the shares. This is the same method used by Google and Lazard. Only two firms will place the offering: WR Hambrecht and E*Trade Securities. And they have already picked out a good symbol: IBKR.

There is a lot of great information about Interactive Brokers in their S-1. For example, did you know that IB makes 7 times more from market making as from their brokerage services? And most impressive, IB’s growth rate is still phenomenal. Their consistent growth is what sets apart IB from the rest of the brokers and makes their IPO very attractive. By early estimates the firm will probably be valued at around the $10 billion range. Which means that with an 85% ownership stake, Thomas Peterffy can afford a few more horses

The only disadvantage is that Peterffy has organized the IB Group in a very complex way and through a dual share structure has ensured that even with the firm in public hands, he will continue to maintain control. This isn’t a totally bad thing when you consider how IB has grown under his stewardship.

I’ve asked my contacts inside IB for more info, so when I hear back, I’ll update this.