Stocks: Financials Hold the Key

S&P says that if shares in the sector can stabilize at current levels, it would give the overall stock market a nice shot in the arm

The financial sector, as well as the financial strains in the credit markets, continues to weigh on the overall stock market, so the performance of financial stocks should be a key driver as we move into the end of 2007 and into 2008. Signs from European bourses are encouraging as the UK's FTSE index appears to be tracing out a head-and-shoulders reversal pattern, while Germany's DAX index is near an all-time high. Sentiment is still tilted to the bearish side, a positive from a contrarian view, in our opinion.

The Financial Sector SPDR ETF (XLF), as well as other financial indexes, are giving off initial clues that the worst may be over, at least from an intermediate-term perspective. We think that if the financial stocks just stabilize at current levels, it would give the overall stock market a nice shot in the arm. We will warn you upfront that it is early in the game and that even if we are correct about the beaten down sector, we could see many more weeks or months of basing action before the stocks reverse to the upside. If the sector breaks down hard again, we think we could get another leg down in the overall market.

The XLF, incredibly, has retraced 50% of the gains it had during the entire bull market from the low in 2002 to the high in 2007. But more importantly, in our view, the ETF has fallen into a fairly large area of chart support that may provide a floor for the sector. This support is derived from the consolidation in 2004 and 2005 that runs from about 27 to 31. This consolidation just happens to sit right on top of the massive base and reversal formation the XLF traced out from 2001 to 2003, and we believe that makes it even sturdier as a potential base.

Taking a look at the 14-week relative strength index (RSI), we also see some potential positives. First, the RSI got extremely oversold in early August, falling to 27. We think this may mark a trough for weekly momentum. This was the most oversold the XLF has been since the bear market low in October 2002. Second, the 14-week RSI has traced out a positive divergence, printing a higher low in November, as the index was printing a much lower price. This is also the first positive divergence, after falling below 30, for the 14-week RSI since the 2002 bear market low.

Moving to a daily chart, the XLF may be in the process of tracing out an inverse head-and-shoulders formation. The ETF tested the left shoulder low in the 29 area on Wednesday, Dec. 12, through Friday, Dec. 14, and held. To complete this potential reversal formation, the XLF will have to break strongly above the 32 area, which represents the recent highs. In addition, 32 was support for the XLF back in August, so there is a fair amount of chart resistance in this zone. So far, the size of the potential H&S pattern does not look large enough to reverse the current bear market. It could take more basing time to trace out a more robust bottom, which suggests that the recent lows are tested sometime in the next couple of months.

The FTSE 100 has traced out a fairly good-sized inverse head-and-shoulders formation, and with the recent decline, is testing the neckline of the pattern. We mention the FTSE as it has led the U.S. markets many times in the past. The FTSE has traced out a much better looking reversal formation than its U.S. counterparts, as the H&S pattern was extremely symmetrical. We still believe that the worst is behind us for the FTSE after the 9.8% pullback, but we think that global markets are walking on thin ice. It will be very important, in our view, to see some stabilization around the world in the near term, as many major indexes are not far from critical support levels marked by the lows in November.

The FTSE has actually traced out two inverse H&S patterns since the beginning of November. The first one was very small, and we did not think this pattern was large enough to be called "the" reversal formation for the pullback in light of the size of the decline. However, the larger H&S appears, in our view, to be big enough in both price and time to sufficiently reverse the prior downtrend.

Both shoulders of the larger H&S formation come in very close together; only about 10 points separate the two. The price peaks of the shoulders are almost exact, and the distance from the head to both shoulders is exactly eight days. It doesn't get much more proportional than that.

The neckline of the pattern sits at 6429 and that was marginally taken out with the decline on Thursday, Dec. 13. The 65-day exponential average also lies right at this level. The 200-day exponential lies at 6391 and the shoulders come in between 6305 and 6315. On the upside, initial chart support is at the recent high of 6565 with trendline resistance, off the recent peaks at 6615. Additional chart resistance runs up to the high in October of 6731.

The 14-day RSI is working on a series of higher highs and higher lows and did not get overbought during the recent rally. The daily MACD has jumped back above the zero line for the first time since the middle of September, a positive, in our view. The 14-week RSI as well as the weekly MACD continue to trace out lower highs, but have also put in a higher low, indicating the potential for a trend change.

The DAX index got very close to making an all-time high with its close over 8000 on Wednesday, Dec. 12, but has backed off a bit. We are not concerned by the pullback as this action is fairly common. Many times when an index approaches a critical area of resistance, it will drop back and get reenergized before it makes a real strong attempt to post a major breakout. The relatively mild 6.6% pullback, much smaller than many of the ones suffered in the global marketplace, suggests to us that markets around the world can right themselves, and that the DAX will once again take a leadership role.

We would have preferred that the DAX did more basing as the reversal pattern was a very small triple bottom that took all of 5 trade days. The index, on a bigger scale, is tracing out a fairly large ascending triangle pattern, and all we need to complete this bullish formation is a breakout above the July high of 8105.69. This price structure is made up of a flat top and a series of higher lows. The measuring implications of the pattern are large, in our view, and equate to over 800 points of potential upside once the index breaks out.

On the downside, chart support is seen in the 7800 to 7830 zone. The 80-day exponential average sits at 7776 and could also act as potential support. Trendline support, off the recent lows in August and November, comes in around 7600 with the 200-day exponential just below this.

On the weekly chart, potential support comes in at 7540 from the 40-week exponential moving average. This average has done a good job of providing support for the DAX during the entire bull market. If the lows from August get taken out, long-term trendline support, off the lows going all the way back to 2004, sits in the 7410 area. The weekly MACD appears to be bottoming, and has remained above the zero line during the entire pullback and base. The 14-week RSI has traced out a double bottom and has broken a string of lower highs, confirming that the trend has turned bullish. The 14-week RSI bottomed out just below the 50 level, higher than during previous pullbacks and a sign of strength, in our view.

Sentiment remains cautious, in our opinion, and we think this supports the case for higher stock prices into early 2008. The NYSE short interest ratio remains fairly elevated at 8.2, not far from the recent all-time high of 9.6 at the end of October. This ratio has been in an uptrend since early 2006, reflecting rising levels of fear in an environment of rising stock prices. We witnessed the same thing back in the mid-to late '90s and it wasn't until the bears threw in the towel and covered their short positions that the market finally peaked. While there is no guarantee that scenario will play out, we still prefer to see a lot of skepticism towards stocks.

The OEX put/call ratio has fallen to bullish levels, in our view, and suggests that the smart money is betting on a rally. OEX options are played by professionals or the smart money and therefore are not interpreted from a contrarian view like other sentiment indicators. The 15-day OEX p/c recently fell to 1.16 from 1.76 in mid-October. This is the lowest and most bullish this ratio has fallen to since June 2006, near a key intermediate-term bottom. Other p/c's that we monitor remain relatively elevated, which, from a contrarian viewpoint, is bullish.

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