Financials to the Rescue?

Things appear to be getting better for this beaten down group, but we believe that much technical repair is needed

Following one of the worst headlines we have ever seen and another mini-meltdown in financial stocks during Monday’s (Mar. 17) trading, a strange thing happened. The financials, which looked down for the count, got off their backs and started throwing their weight around, in one of the most remarkable turnarounds in a long time. Meanwhile, after the Federal Reserve cut rates "only" 75 basis points, the U.S. dollar also woke from its long-term slumber, crushing what have been working for so long, commodity prices and their respective stocks.

From the close on Monday until the close on Thursday (Mar. 20), or in 3 trade days, financials skyrocketed. Of course, the moves are after major meltdowns so they are not as big as they seem. Nevertheless, the shorts are likely feeling it after this recovery. Some of the bigger gains: Freddie Mac (FRE) +58%, Fannie Mae (FNM) +54%, Lehman Brothers (LEH)+53%, Countrywide Financial (CFC) +41%, Centex (CTX) +26%, and Washington Mutual (WM) +27%. The S&P Financials SPDR (XLF) jumped over 12% from Monday’s closing low and rose over 18% from Monday’s intraday low.

So, is the worst over for the financial sector? Unfortunately, it is too early to tell, but we are starting to see some mildly positive signs. Of course, any time a sector can turn around intraday on a horrendous headline, it should get your attention. So what is the chart telling us?

The XLF is still in a bear market and at Monday’s low was pretty close to retracing the entire bull market that took almost five years. From the high in June to the intraday low Monday, the ETF had plunged almost 42%.

If the XLF is bottoming, we think that the most likely reversal pattern will be an inverse head-and-shoulders pattern. So in the near term, this allows for some more mild gains followed by another mild down leg that holds above the recent lows, in our view. There is a thick layer of chart resistance between 26 and 30, so we believe any continued strength into that zone will eventually fail as supply overwhelms demand. In addition to this chart resistance, a 38.2% retracement of the entire decline sits right above the 28 level. Trendline resistance, off the peaks since October, lies at 27.5, while the 80-day exponential average also comes in near this level. With this much overhead, we think it is very unlikely that the financials can mount an intermediate-term uptrend.

From a momentum standpoint, we are seeing some positive signs. Both the 14-day and 14-week RSI have put in a couple positive divergences. This suggests that the downward momentum is starting to wane. There have also been two bullish divergences from the daily MACD indicator. We have seen a nice jump in relative outperformance vs. the S&P 500 since Monday; however, the long-term trend is still lower.

Overall, while things appear to be getting better for this beaten down group, we believe that much technical repair is needed on the charts and any bullish reversal formation is likely to take at least another month or two.

On the flip side, a little rally in the U.S. dollar crushed the commodity complex. Gold prices plunged $81/ounce in two days, or just over 8%, one of the worst drops in decades. The U.S. Dollar Index, which was one of the factors blamed for this plunge in gold, rose less than 2%.

Our guess is that there was a lot of profit taking in commodities, as they had gotten very extended and overbought on a technical basis. Crude oil also took it on the chin, falling from over $110/barrel to below $100/barrel on an intraday basis Thursday. In the last two days of the week, some of the big losers in the materials and energy sectors included: Monsanto (MON) -13%, Freeport-McMoRan (FCX) -12%, Alcoa (AA) -10%, Newmont Mining (NEM) -10%, and EOG Resources (EOG)–9%. We think the money flowing out of the commodity trade and into the financials is short term in nature, and believe we are seeing a correction in commodities within the confines of a long-term bull market.

As we have gone over many times in the recent weeks, market sentiment is horrible, and we believe that will eventually be good for stocks. What we need, in our view, is to see that sentiment start to unwind back towards the bullish side. The bearish side is awfully crowded as the "dumb money" indicators are showing extreme fear, while the "smart money" indicators and investors are indicating more of a liking for stocks. We'll stick with historical precedents and still believe that the risk is for a move to the upside.

We hate to say this, but if we were to move into another down leg, it would be unprecedented based on the sentiment data we have, some of which goes back many decades. Of course, who thought Bear Stearns would be bought at $2 a share?