Trader’s Narrative

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).

Interesting article on Goldman Sachs’ “luck” in escaping unscathed from the sub-prime mortgage mess:

Goldman’s good fortune cannot be explained by luck alone. Late last year, as the markets roared along, David A. Viniar, Goldman’s chief financial officer, called a “mortgage risk” meeting in his meticulous 30th-floor office in Lower Manhattan.

At that point, the holdings of Goldman’s mortgage desk were down somewhat, but the notoriously nervous Mr. Viniar was worried about bigger problems. After reviewing the full portfolio with other executives, his message was clear: the bank should reduce its stockpile of mortgages and mortgage-related securities and buy expensive insurance as protection against further losses, a person briefed on the meeting said.

The article fails to mention that Goldman Sachs (GS) is Wall Street. They might as well own it outright. And now they’re making inroads into government where policy and oversight reside. They don’t play the game, they are the game.

But in the end, even if you practically own the place, risk and its management is the real game:

At Goldman, the controller’s office — the group responsible for valuing the firm’s huge positions — has 1,100 people, including 20 Ph.D.’s. If there is a dispute, the controller is always deemed right unless the trading desk can make a convincing case for an alternate valuation. The bank says risk managers swap jobs with traders and bankers over a career and can be paid the same multimillion-dollar salaries as investment bankers.

One of my favourite market axioms is “Discipline over conviction.” There is no point in risking ruin when you don’t have to. Coming back to play another day is a prime victory. Had Niederhoffer hired one or two risk controllers, he wouldn’t have blown up (again).

This graph tells the whole story:

By the grace of hindsight, the riddle of their weak relative strength is crystal clear. The market was telegraphing the coming correction and the crisis in the sub-prime mortgage sector.

But just as this sector signalled weakness in early summer, yesterday and today I noticed the opposite. While the general market broke down below its previous lows, the financial sector didn’t. It grudgingly inched lower but held its ground for the most part. And today, it rallied to close up almost 5%.

This is after all, the sector that wears an albatross around its neck. The guilty party that caused us all this grief. Why would it be showing strength? especially as all around it shares were being getting pummeled?

I suspect the message of the market this time is that the worst is over. Giant, well diversified financial institutions like Goldman Sachs (GS) and Citigroup (C) are not going to fold over this. They’ve weathered storms before and they will weather this one.

Take a look at the Phili Banking Index (BKX). Hmmm… is that a double bottom?

Last Monday I gave the heads up on the financial sector because its bullish percent index was at an extreme low. In the following days both the sector and the bullish percent index continued to fall.

In fact, the financial sector bullish percent index fell to below 26. A level which it had only seen in the deepest, darkest days of the bear market in late 2002.

As you can imagine, there was a lot of fear and loathing in the air. A lot of uncertainty. Talk of a big bank going under, the sub-prime mortgage mess spreading, etc. But the best time to buy is when everyone is scared witless. That is when you find real bargains.

Unless it is the end of the world, in which case you’ll have bigger things to worry about.

It wasn’t just the bullish percent, by the way, that was signalling the extreme situation in the financial sector. The percentage of stocks above their 200 day moving average fell to 10%. Again, something that had only happened in the final days of the bear market.

Things have bounced back from the brink but we’re still very oversold. Right now only 12.5% stocks closed above their 50 day moving average. I expect this sector to continue to slowly claw its way back. If you haven’t gotten in, there’s still time to buy great banks, brokerages and insurance companies at firesale prices.

Although I use the bullish percent index a bit differently, the traditional interpretation has been satisfied: when the index falls below 30 and rises above it, a bull or buy signal is given according to point and figure charting.