It’s Make or Break Time for Banks

The financials sector, especially the large money center banks like JP Morgan (JPM) and Citigroup, were among the strongest performers following the election with the SPDR Financial (XLF) rallying some 20% in the month after the election.

The group then consolidated sideways for two months before pushing to new highs surrounding hopes for tax reform, accelerated interest rate hikes and deregulation. But the prospects for fast implementation of those policies quickly faded and so did shares of the banking sector.

The chart now looks like a bearish head & shoulders pattern. As the charts now sit on key support levels and with an ECB meeting this week and the FOMC meeting next week, this could be make or break time for the financials. Which could in turn influence how the broader market moves in the coming weeks.

 

While the financials don’t carry the near 30% weighting of the S&P 500 they represented during the 2004-2008 years, it’s still large enough at 18% to have a significant impact on the index at large. The influence of the financials actually goes beyond just the share price contribution to the indices; the health and profitability of banks is a bellwether of the economy at large.

Meaning I think it will be hard for both the stock market or the economy, which often seem to act disconnected, to improve without participation of the banking sector. So, it’s with definite concern to see the XLF a full 10% below its recent high, even as the broad indices march to consecutive all-time-highs. Something’s gotta give.

Now before I start waving my red flag too wildly I should note I established a bullish position in Morgan Stanley (MS) yesterday for myself and members of my option based newsletter.

Admittedly, at any given juncture in the stock market, there are number of conditions folks can point to as potential warning signs for the market. Certainly, those with bearish inclinations will seize upon such conditions to explain (or promote) their view. The recent under-performance of banks and financial stocks would be such a caution flag. Even bulls would have to acknowledge the reality of this under-performance, which, in fact, recently reached an ignominious milestone.

But as Dana Lyons points out with the chart below there have been 9 prior occurrences when S&P 500 Index is hitting new 5-week highs while the Bank Index (BKX) 10% below its 52-week high. The question is if it is clear this is condition is truly a red flag for this bull market?

We can see from the chart a few of the historical occurrences took place in close proximity to market tops of some magnitude. Ned Davis Research claims financials are notoriously one of the weakest sectors leading up to significant market tops.

However, I would also argue far too seldom do folks actually crunch the historical data to determine whether or not various conditions actually warrant the “warning label”, assuming historical patterns have any implications for present or future market behavior.

Thus, while bulls would certainly prefer to see financial stocks hitting new highs along with the major averages, we would caution against assuming this divergence is an automatic death knell for the rally.

— Steve Smith