Trader’s Narrative

The financial sector, as measured by its proxy, the Philadelphia Banking Index (BKX) has definitely broken down. I said as much before the end of last month. While it seemed that the line everyone was watching (level 75 on the chart) might act as support, it didn’t convince me.

While it put up a bit of a struggle dancing around the line for 3 more trading days, it has now decidedly broken down:

The red line marks when I suggested that the sector would break down. The next support, as you can see, is still some way down. So I would stay away from the long side until it reaches that level.

But the good news is that if or when it does plumb those depths, there is a good chance that it will find significant support. It will be fourth time, after the 1998 LTCM bottom, early 2000 and the late 2002 bear market floor.

There is some technical support level at 70 but before a definitive bottom can be in place this sector may need to get to real support and wash out all the weak hands.

And 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:

That would be, at least, a 20% points drop. Until then, while rumors like those swirling around Lehman Bros. (LEH) may fly and the negative sentiment may get even thicker than it is right now, I doubt that this sector will find its footing.

But while this may be bad news to those long banks, or other financial stocks, I don’t think that it necessarily means the market itself is somehow doomed. A bull market doesn’t need financial stocks.

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.

On Wednesday - February 13th - after 3 consecutive up days, I mentioned the peculiar way that option traders were in denial of the rally and of the likelihood of seeing a pause:

It would be very normal for the market to pause and digest this short term move up but the negative sentiment is undeniable.

We got the “pause and digest” the following day on Thursday and today. So to dive into all that negative sentiment, here is the stock market sentiment recap for this past week:

LowRisk.com
I mention this sentiment survey sparingly because it is very jittery and much less famous than its peers. But this week’s reading of 64% bears and 24% bulls reminds me of the last time that bearish sentiment was 60% (June 2007).

Unlike then, this week’s bullish ratio (bulls divided by the sum of bulls and bears) is quite high at 27.27%. But there is no denying that the respondents are very gloomy about the Dow’s prospects. Their median guess of the Dow (closing value February 22nd) was 11852 - well below the Dow’s January swing low of 11,970.

Investor’s Intelligence
If you’ve been keeping up to date with these sentiment overviews then you know that the II survey has been insistently and stubbornly stuck with a clear bullish consensus. For contrarians, that has been disconcerting not only because II is a major sentiment survey but because it contradicted all the other surveys.

This week it seems “reason” has finally prevailed in newsletter land. According to ChartCraft, the keeper of this indicator, the bears now account for 35.6%, and the bulls 36.7%. While that may seemingly put them neck and neck, the historical data for this survey gives us a decidedly more bullish interpretation.

Newsletter editors are naturally bullish by nature, after all, optimism sells. So it is almost impossible to find less than a third of them bullish at any point in time, no matter what the market condition. The current percentage of bulls is as low as it was in the summer of 2006 and 2002 (and no other time since). So I can comfortably say that the II is officially flashing a contrarian buy signal - finally!!.

AAII
Meanwhile, the AAII (retail investors) sentiment has finally decided to come up for air from the depths of despair it had sunk to in January 2008. The AAII sentiment survey spent 5 consecutive weeks (December 21st, 2007 to January 18th, 2008) being 50% or more bearish. The bears are now “only” 42% (with the bulls at 33%).

We’ll have to wait a few more months to see if the stock market follows the previous script or if we stray. According to the above chart, we could find the S&P 500 at 1558 by June 2008.

That’s not a prediction, by the way. I’m just extrapolating from the historic averages. But it could turn out to be prescient, so write it down somewhere or bookmark this so you can come back and mock me

Consumer Sentiment
The most recent Reuters/University of Michigan’s consumer sentiment survey was released today and it shows a stumble from 78.4 to 69.6 - the lowest since 1992!

As I’ve discussed before, consumer sentiment measures are a contrarian indicator. By the time they reflect doom and gloom, it is too late to sell, and in fact a better time to buy.

Whether that is because of the time lag built into this kind of survey or whether it is because of the forward discounting ability of the stock market (or both), the historical evidence shows that significant lows in consumer sentiment are buy signals for stocks.

I’ll going to write more about this indicator soon.