Trader’s Narrative

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.

Two weeks ago I wondered if the financial sector had suffered enough… no, it hadn’t.

But things look quite different now. Today and yesterday we had a remarkable change in tone for this sector. Snap back rallies in a declining trend are characteristically sudden and intense but none of the recent ones in this sector approach what we saw this week:

To add to yesterday’s rebound we had an almost 12% advance. Some of this is due to short covering. ok, a lot of it is due to short covering. But still, this sector was the favorite punching bag of all hedge funds looking for an easy short trade. Not anymore. The shorts are being squeezed like crazy.

Understandably, we snapped back from a tremendously oversold condition. A measly 7% of stocks in the financial sector were above their 200 day moving average. And the bullish percent index didn’t brake until it had broken through 6%. Six percent!

To put that into perspective, here’s the chart I showed last time updated (going back to 1997):

I find it astonishing that this sector could get crushed even more severely than it did than during such periods of financial turmoil as the 1998 LTCM crisis and the popping of the Internet bubble.

In poker, a “tell” is any change in the pattern of behavior by a player that gives insight into their strategy. It could be anything: how fast they bet, how they throw their chips in, feigning ignorance or interest, etc. You can’t really win at poker if you don’t have a mastery of tells.

In the same way, the stock market provides “tells”. If you know where to look. Today’s market tell, as I mentioned yesterday, was obviously, Citigroup (C).

Let’s take a look at today’s intra-day action to see what this market tell offered us. As you’ll see from the chart, Citigroup acted as a reliable tell by breaking down from its morning range before the market did.

It then continued to lead the market in sinking lower. So if you were watching Citi, instead of, or at least in conjunction with, the general market indices, you would be able to react much faster.

The concept of a market tell is a useful one but just like in poker, the “tell” itself can change from hand to hand. So while today’s market tell was obvious, tomorrow’s may not be.

Over the next few months and even till the end of the year, I’d be willing to “forecast” that we will close higher, but for the next few days and weeks, the market may be heading into some kind of a short term top or choppy trading.

I was looking over some different indicators to take the pulse of the market when I noticed that according to the ISE Sentiment there are too many calls being bought compared to puts right now.

In fact, the ratio is at levels which have in the past marked market tops. As you may recall from the last time I talked about the ISEE data, it only measures opening long customer transactions on International Securities Exchange. Which makes the data very useful, especially considering the growing volume of options traded on the ISE.

Take a look at the graph below which compares the S&P 500 to the ISEE sentiment data. As you’ll notice, when the 10 day moving average rises too much (too many calls bought to open, compared to puts) the market has a hard time powering ahead. It either swoons or enters into a sideways range.

There’s no magic to the number 10 by the way. Any short term moving average would smooth out the data and show you the same thing (more or less).

On Friday, the market was jolted down quite harshly. Although the move printed a wide range candle on index charts, it did not result in any sort of oversold readings. So the market certainly has room to the downside. And you have to remember that a bull market never makes it easy. It bucks at every chance to try and throw you off.

If we do see some general market weakness though, I’d really be wary of the soft sectors like the financials. The banks and brokers will most probably get the brunt of any serious selling since they are already very weak relative to the market.

Click to Enlarge Graph:

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: