Trader’s Narrative

In the final days of last November, the financial sector looked cheap. Their bullish percent index was 16% and with news headlines about recession, sub-prime mortgages and the credit crunch, negative sentiment about them was rampant.

Things are very stretched to the downside here and we are ripe for a snap-back rally.

The Philadelphia Banking Index (BKX) in fact did snap back by 10% - after falling more than 20% from its high in October 2007. This counter trend rally took the financial sector bullish percent index up to 55%. But while profitable, for those that rode it, the rally was fleeting.

Change in Tone
Fast forward to now: The BKX has bounced feebly off the 75 support line 4 times and it is now trying to do so a fifth time. While it may succeed to cling to support and rescue itself from the impending drop, I’m beginning to have my doubts.

That’s because somewhere between then and now, the way financial stocks react to rallies changed fundamentally. They started to act as if they were in a bear market, rather than a bull market. When it came to fall, they did easily but rallies only produced reluctant gains.

Take for example the incredibly low bullish percent reading in mid-January 2008: 5.5%. That should have launched a massive and protracted recovery. While the bounce was significant, 25%+, it petered out below the December rally high. This created a lower high after a lower low. As you can see from the long term chart, the next support level is painfully far away; between the 70-65 range.

In fact, we could argue that the financial sector’s tone changed sometime in mid 2007. The BKX itself fall below its long term moving average (200 day) - transitioning quickly from Stan Weinstein’s Stage 3 to Stage 4. Then if that wasn’t enough, the bullish percent corrections where no longer limited to the shallow retracements to 50-60% as before:

So now as everyone is watching this sector flop around the 75 line, I have my doubts that it will be able to hold support. Primarily based on the relative weakness of the sector and based on the relative high reading of the bullish percent index:

At just below 50%, the bullish percent index could potentially fall to 10% or less before we see another counter trend rally. And that would mean that the index itself would invariably have to fall well below the support line.

But this itself isn’t as significant as the portent this has for the general market. Financial stocks, are after all, one of the most important sectors. Their health (or lack thereof) is vital for the stock market. No major bull market can be launched and no significant rally sustained without the participation or leadership the financial stocks.

Here’s a chart of +50 years of the intended Federal Funds rate:

Now is an appropriate time to take a step back and look at the bigger picture because what the Fed has just done is extremely rare.

It has reduced the interest rate by more than 43% in less than 6 months. To find such a frantic slashing of rates we’d have to go back to the Volcker years in the early 1980’s.

The only other time in recent history that is remotely similar is the aftermath of the 9/11 tragedy in late 2001.

What makes it intriguing is that unlike the 1980’s and 2001 when everyone knew something horrible had gone wrong, we don’t really have that now. I think it will take some time for us to understand just what happened.

It seems surreal now as we are going through it. Perhaps the only way to understand it is through the perspective of time. Who would have believed that the current credit crunch makes the 1998 crisis pale in comparison?

So the Fed came in with a 25 basis point cut, as expected by the markets, and everything went to hell in a hand basket. Hmm, I wonder if you can tell when, exactly, the news came out:

The bond market closes at 3pm, while the equity markets close an hour later. So stocks had one more excruciating hour of pain.

Within less than 2 hours, it had erased almost 4 days of uphill climbing. This is what I wrote a few days ago:

With the impending FOMC decision, traders are going to be twitchy and nervous. Although a 25 basis point cut is baked in, until we get confirmation, the market will probably not trend.

It is all about expectations in the market. Since a quarter point cut was already expected and priced in, the market had rallied accordingly in the days leading up to it. The only thing that would have kick started another rally would have been a half-point cut.

Recession Forestalled?
According to Morgan Stanley, recession may be inevitable now. In a new report written by the bank’s chief US economist Dick Berner (the resident bull) the prime culprit is the credit crunch which has lasted more than 17 weeks and brought the housing market to its knees.

…financial conditions have tightened significantly further as the price of credit has risen and lenders have made credit less available. Money-market rates have risen significantly, and yield spreads over those money-market rates on loans have stayed high or widened.

The bond market has already priced in the next rate cut in January - another 25 basis points. And into the summer of next year, the Fed Funds Futures market is now estimating a federal fund rate of 3.75%.