Wednesday, July 2, 2008

Getting Tougher to Push Financials Lower from Here?

Halfway through today’s session, my screen is once again filled with red, as the indices look as if they are poised to take a run at yesterday’s lows.

From a sector perspective, the picture is considerably muddier, as two recent laggards, financials (XLF) and consumer discretionary (XLY), are clinging to positive territory as I type this. As I see it, one or the other of these sectors will have to continue to deteriorate if the markets are going to continue lower from current levels.

Given that the financials are already down 53% from their May 2007 highs (see chart below), it is important to keep in mind that the easy money has already been made on the short side. A wide variety of financial sub-sectors (mortgage companies, bond insurers, money center banks, regional banks, investment banks/brokers, etc.) have already made multiple trips to the woodshed – and while some individual issues may still be quite vulnerable going forward, there is a limit to the amount of blood that can be squeezed from a broad-based ETF or index.

Going forward, I suspect the risk/return profile of the financial sector may actually favor the bulls. If the next couple of broad market moves down fail to pull the financials with them, the path of least resistance for the likes of XLF may indeed be up. Keep an eye on this development, because if (and admittedly this is a very large “if”) the financials are done falling, then the markets are likely to be ready to put in a bottom too.

5 comments:

Anonymous said...

$55 range is the 10 year low on $BKX. Are banks in better shape today than 1998?? VIX appears to think so and that could be what pushes all indices to new lows

--dowoper8tr--

SimpleTrade said...

I think XLF will bounce at least back to $22-23 area short term. The market is one event away from a big bounce. Unless, of course, Israel attacks Iran.

eh said...

I notice you don't mention the broader macroeconomic picture -- which is by most measures deteriorating significantly -- when talking about a market bottom. Why is that? Don't you think that if the general economy continues to deteriorate that the market will fall further regardless of what happens to financial stocks? Do you think it's impossible or very unlikely that the market could fall further and not drag the financials down with it?

eTrader said...

If history rhymes, and if US is following the way Japan came through, I would say there is no bottom for financial sector.

Bill Luby said...

There are several good points in this thread. I was going to omit a response, but since the last two commenters changed the theme from a technical one to a fundamental one, I feel obliged to make a couple of points -- particularly since I don't comment on macroeconomic issues here as much as I probably should.

First off, I have been much more worried about financial institutions than the resiliency of consumer spending, although I realize there is a linkage between the two.

Bank capitalization is an extremely important issue -- and it needs to be looked at as a moving target. If loan portfolios stabilize and credit markets slowly regain some liquidity (the python may indeed eventually be able to digest the cow), then bank capitalization can proceed at an unhurried pace.

My biggest concern is how much deterioration there continues to be in mortgages, HELOCs, auto loans, credit cards, and other types of loans that make up a bank loan portfolio. If these continue to go south, then the bank capital requirements keep growing, the dollars needed keeps rising, and liquidity will get worse. This is the type of vicious cycle where things can spiral out of control quickly.

Given the above scenario, I would be foolish not to think that the general economy cannot continue to deteriorate and drag the financials down with it. Frankly, I think there is a reasonable possibility that this will happen to some degree or another. I see a more likely scenario of say 3-6 quarters of flattish GDP in which the financials slowly repair their balance sheets in a flat economy -- with their stocks recovering as the talk of a 1930s style US depression (or 1990s style Japanese 'lost decade') begins to recede.

We should know a lot more about what the next few years will look like by the end of the third quarter.

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