Wednesday, July 23, 2008

Headwinds Index: How Long Can Financials Outperform Energy?

Two weeks ago, I introduced something I called the headwinds index, a simple ratio of financials (XLF) to oil (USO). It took another week for that index to bottom and the markets to rally, but since that bottom, financials have jumped 37% while crude oil has fallen 14% from its peak. The headwinds have turned into a strong tailwind, at least for the past six days.

The question, of course, is how long financials can continue to gain ground before a new long oil, short financials trade becomes too attractive to pass up. Several of my indicators suggest that the tailwinds are about to dissipate in the next day or two; after a strong opening, today’s developing gravestone doji also calls into question the staying power of the recent trend reversal.

At a minimum, I suspect the new tailwinds have gotten ahead of themselves. When they start to move back in the wrong direction, there is little reason to remain in the long financials, short oil trade past its useful life. As sailors are fond of saying, “tack on a header!”

8 comments:

Eric said...

That would be sweet, if only I could get a shot at WFC back in the 20's again.....

Eric said...

I think there will be a pullback on this ratio, but if Dolly doesn't tear up too much, it has more run on the upside. Maybe it wasn't speculation on Oil that made it run up, I think it was some confirmatory bias to the upside on Oil & the downside on Financials. I truly believe this has reversed. I think money flew out of Financials and found it's home in Oil. I think we had a negative bias on Financials that has now turned. The Chaikin Money Flow indicators on USO & XLF were very interesting last week and confirmed a reversal towards the mean. You have real global growth, devaluation of the dollar, political instability concerns. And each one of these concerns though real, were exaggerated. [as i write this oil took another drop toward $25 near the close and I just bought Aug $93 Puts on USO.]
Global growth will slow, I think the dollar is gonna make a push back to the 1.40 - 1.50 range on the Euro/USD. And I think there is some positive expectation on dealings with Iran.

Anonymous said...

The dollar will reverse, but only on interest rate increases that will completely destroy housing.

When housing is destroyed, the economy hosed.

Bailout or not, nothing will stop the fact that houses cost 5-10X median income.

That ratio must fall to 2-3X to retain historical growth.

Until that happens, financials are completely screwed.

Redshark said...

Friends ask me frequently if it is a good time to buy banks; my standard answer has been "When CNBC does not mention the financials hundreds of times a day and they are not on the front page of the WSJ, it will be a good time to buy." Even if we have hit a "bottom" in the financials, we will be able to buy them closer to the bottom than the top.

This current credit crisis reminds me most of the Enron fallout. This is probably a fleeting memory for most, but a lot of utilities got hit hard and many did not survive. Here is a very crude chart I threw together in Excel (I am sure Bill could put something much nicer together).

http://img177.imageshack.us/my.php?image=epbackg0.jpg

This chart shows El Paso Energy (EP) during the fallout of the Enron fiasco against Bank of America (BAC) currently. There are obvious correlations, but my point is look at how long you could have bought EP under $10 or under $15.

I had to divide the BAC volume by 10 to get it to scale properly. If you wanted to make a case for BAC being at a true once-in-a-lifetime bottom, you might be able to say something about the volume here, which is a little bit hard to see in the chart (semi-transparent green bars). The volume appears to be much more dramatic right here, but I still think an investor will have plenty of opportunities to buy BAC in the 20's.

Redshark said...

I would also add that I have had a position in BAC and JPM for the past couple of months, and the only thing that has kept me above water is aggressive call writing against my position. Regardless of the future direction, I think we would all agree that there will be further short-term volatility ahead. I am looking to put on a credit spread against my position in the next couple of days, where I sell an out-of-the-money call several months out, and buy a put for the front month or the next month out. At least you can sleep at night this way.

Eric said...

Redshark. Did you get nailed with the JPM/BAC calls against your positions after the reversal last week?

Redshark said...

Eric,

I had no call position on at the time. I did not sell calls last month, because I felt it was not a good time to be selling that low. It stung a little bit, but at the same time I did not get in a position were my calls got nailed. At the moment I am looking at putting the following trade on against my long stock position:

Sell Nov 30 BAC Call
Buy Sep 30 BAC Put

Sell Nov 37.5 Call
Buy Aug 30 Put

This would have worked out a lot better if I got it off on the open. Particularly on the latter, not much of a spread left there now. This will be the fist time I have put a credit spread against my bank stocks, I have done it on other positions, but with this volatility it seems like a good idea. Normally my trade has been selling front month calls, here I am going a little bit farther out. The thing to watch here is the ex-date on the dividend, however this still gives me 2-3 months of protection and time to wind up my options positions.

Redshark said...

Eric,

I came up with another idea to represent what I mentioned earlier about how we still have plenty of room to be long the financials or WFC in your case. My initial idea was much more scientific, but it did not pan out. I ended up just using Google News Timelines, which I think has quit a bit of room for error. However, I believe the trend is still in tact.

This is a chart of the end of month closing price for El Paso Energy, against the number of news stories Google returned for the same month.

http://img515.imageshack.us/my.php?image=epvolumedg1.jpg

As you can see, there is no meaningful trend reversal until the news stories die down. I think we are again in a similar circumstance.

Here is a link to the Google News Timeline for Bank of America. I think we all know what the stock chart looks like.

http://news.google.com/archivesearch?q=Bank+of+America&hl=en&ned=tus&sa=N&lnav=m&scoring=t

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