Bearish Financial Sector Divergence Stokes 2007 Crash Memory

Since their inception, the SPDR S&P 500 ETF has almost always confirmed new highs of its cousin, the Select Sector Financial ETF. The only time it didn’t was in 2007 … and today. Here’s what makes this potential repeat intriguing.

For all the Whac-a-Mole bears who’ve been getting clobbered by the omnipresent bull market mallet, there’s finally a faint ray of hope flickering out of the same black hole that caused the last financial meltdown – the financial sector.

True, the Financial Select Sector SPDR ETF (NYSEArca: XLF) is humming higher, but the SPDR S&P 500 Bank ETF (NYSEArca: KBE) is not.

To be exact, the KBE bank ETF is trading 6.5% below its March high while the XLF financial ETF has already edged out new recovery highs. That’s unusual.

The chart below shows that since its inception, KBE has confirmed every significant new XLF high (dashed gray lines). Only two exceptions (dashed red lines) created a bearish divergence:

  • May 2007
  • August 2014

Although we don’t need the aid of a chart to remind us of what happened post May 2007, the chart tells us anyway.

Obviously, it would be premature to bunker up and batten down the hatches based on a sample size of one.

Even if the 2007 scenario is playing out again, it’s too early to pencil in a market crash in your 2014 trading calendar. Why?

  1. There’s a grace period between the XLF high and the final S&P 500 (NYSEArca: SPY) high. In 2007, the S&P 500 rally continued five months after XLF topped and the market didn’t enter free fall territory until a year after XLFs all-time high.
  2. XLF just saw a technical breakout. This looks bullish on the chart until proven otherwise. However, the breakout mimics a prior pattern that failed (see “XLF Breaks above Resistance to New 6-year High” for more details).

A small detail many have already forgotten is that the S&P 500 dropped nearly 12% in July/August 2007 just before shooting to its final October hurray.

A similar pullback now would certainly make this financial sector divergence even more intriguing.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

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Leading U.S. Sector ETFs Send Mixed Messages

Every bull market is built on the shoulders of strong leading sectors. Things tend to get dicey when the leading sectors start to lag. Here’s a look at three leading sector ETFs and some interesting developments.

Looking at leading or lagging sectors can provide clues about the overall health of a bull market.

This article will look at three leading sectors.

Retail Sector – SPDR S&P Retail ETF

The SPDR S&P Retail ETF (NYSEArca: XRT) soared 42.29% in 2013 and was heading for a strong finish (many thought). Retailers love the holidays (November/December), but the 2013 holiday period wasn’t kind to retailers.

As the XRT chart shows, retailers topped in the last week of November and are threatening to break below green support.

A breakdown around 83.50 and 80 for XRT would spell trouble.

Financial Sector – Financial Select Sector SPDR ETF

The financial sector has been leading the S&P 500 for much of 2013 and confirmed Wednesday’s new S&P 500 high (XLF closed 2013 with a 35.52% gain).

Unlike the S&P 500, the financial select sector SPDR (NYSEArca: XLF) is trading well below its all-time high. In fact, it is bumping against 50% Fibonacci retracement resistance at 22.01.

It will take sustained trade above 22.01 to unlock higher up side targets.

Small Cap Stocks – iShares Russell 2000 ETF

Small cap stocks tend to outperform large cap stocks in December/January, but the iShares Russell 2000 ETF (NYSEArca: IWM) has been on fire almost non-stop, up 38.69% in 2013.

Next notable resistance for IWM is around 119 (2002 Fibonacci projection).

Corresponding resistance for the Russell 2000 Index is at 1,166. Unlike IWM, the Russell 2000 Index is already trading above this resistance.

Summary

It’s said that a fractured market is a sick market. We are certainly seeing some ‘unhealthy’ divergences between the various leading sectors (this doesn’t even take into consideration the most recent Dow Theory divergence).

However, XLF and the Russell 2000 Index are at the verge of overcoming their resistance levels. A strong financial sector and small cap segment could also buoy the S&P 500.

The strong 2013 performance of all three leading sectors begs the question if there’s any ‘gas left’ for 2014. The following articles takes a look at how much up side is left:

Did the Strong 2013 Market Cannibalize 2014?

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (stocks, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Most Despised Sector is Leading Charge into Correction Zone

posted on iSPYETF on 11-23-2013

The Financial Select Sector SPDR ETF (XLF) is leading the charge to new (recovery) highs. Unlike the major market indexes, XLF is still having to deal with overhead resistance, such as this solid Fibonacci level.

People dislike injustice and QE is a blatant display of injustice. The Federal Reserve is helping out big banks while the little guy is left holding the bag.

Whether we like it or not, the financial sector is leading the latest charge to new all-time highs for the Dow Jones and S&P 500.

The Financial Select Sector SPDR ETF (NYSEArca: XLF) has broken above resistance provided by the September 2001 low and is heading for the next technical milestone – the 50% Fibonacci retracement (see XLF chart below).

The 50% Fibonacci retracement at 22.01 was isolated as target for this rally in my July 12 analysis of the XLF ETF.

Despite recent strength, the Financial Select Sector SPDR ETF still hasn’t even recovered 50% of the points lost from 2007 – 2009.

As of today, the Financial Select Sector SPDR ETF is about 2% away from the 50% Fibonacci retracement.

The SPDR S&P Bank ETF (NYSEArca: KBE) is about 5% away from its 50% Fibonacci retracement.

Does this Fibonacci level matter? The XLF chart chronicles how the financial ETF responded to the 23.6% and 38.2% Fibonacci levels.

The interaction with the 23.6% level was intense and saw a number of tests. The 38.2% level halted XLF’s advance just briefly.

It would be reasonable to expect some sort of reaction to the 50% Fibonacci level.

It’s a good idea to keep an eye on XLF (and KBE) here as the financial sector accounts for 16.19% of the S&P 500 (NYSEArca: SPY). This doesn’t mean that the tail wags the dog, but the performance of XLF and KBE may provide a sneak peek for what’s next for the S&P 500.

At the same time, the Dow Jones is reaching the long-term target we called for many months ago … and it’s not Dow 16,000.

Reaching this Dow target has been more than a decade in the making: Forget Dow 16,000 – Here’s the Real ‘Bubble Popper’

Simon Maierhofer is the publisher of the Profit Radar ReportThe Profit Radar Report uses technical analysis, dozens of investor sentiment gauges, seasonal patterns and a healthy portion of common sense to spot low-risk, high probability trades (see track record below).

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The XLF Financial ETF Chart Looks Ominously Bearish

Uncertainty is one of the annoying staples of investing, but there are times when risk and uncertainty can be reduced to an absolute minimum. The Financial Select Sector SPDR ETF (XLF) is at such a low-risk inflection point right now.

Technical analysis is not infallible, but sometimes it allows you to pinpoint key inflection areas.

The Financial Select Sector SPDR ETF (NYSEArca: XLF) is at such a key inflection point right now.

The financial ETF (XLF) chart below offers a wealth of information:

1) XLF is butting against resistance created by the May 22 high.
2) The rally from the August 28 low has almost exactly retraced a Fibonacci 61.8%.
3) The current rally high could almost be considered the right shoulder of a head-and shoulders top (although there’s no real neckline).
4) Key resistance is at 20.32 – 20.60.
5) Key support is at 19.50 and 19.30.
6) There is a bearish RSI divergence at the July 23 high.

What Does All This Mean?

As long as trade stays below 20.60, odds favor lower prices ahead for XLF, potentially a sizeable decline.

How to Trade

There are two low-risk ways to trade XLF:

1) Go short now with a stop-loss above resistance or
2) Go short once support is broken.

Those are low-risk trades, not no risk trades.

Why Low Risk

Support/resistance levels act like traffic lights. A car driving down the street is most likely to stop (and reverse) at a traffic light. It doesn’t have to, but if the light is red it has to stop.

The XLF resistance level acts like a traffic light. XLF doesn’t have to stop there (in fact, a bullish case can be made if XLF breaks above resistance), but if XLF is going to stop and reverse, it will be at this ‘light.’

Overhead XLF resistance provides a stop-loss level, which exactly defines the risk of the trade. The potential gain is significantly larger than the potential loss, putting the risk reward ratio in favor of the short trade.

Only trading low-risk setups like this one results in about 60% winning trades, but the gains of the winning trades are 3-4 times bigger than the losses of the losing trades. The Profit Radar Report specializes in spotting such trade setups. The green bubble (August 5, 2012), marks when the Profit Radar Report stated: “Financials are currently underloved. With such negative sentiment, a breakout above 14.90 could cause a quick spike in prices.”

XLF echoes the current position of the S&P 500 (NYSEArca: SPY), which trades at a similar inflection point. The Nasdaq (Nasdaq: QQQ) has rallied much further than the S&P 500, the Dow Jones on the other hand (NYSEArca: DIA) has yet to catch up to the S&P 500.

Regardless of the short-term outlook for XLF, the financial sector is still plagued by serious issues.

Out of all people, it’s Hank Paulson – former Treasury Secretary (during the 2008 financial crisis) – who is addressing the vulnerability of the financial sector and actually warns of another financial ‘firestorm.’

More details here: Hank Paulson Warns of Another Financial Crisis

Simon Maierhofer is the publisher of the Profit Radar Report.

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Dow Jones Component Reshuffle is Bearish for Stocks

The Dow Jones Industrial Average is about to undergo the most significant changes in a decade. The featured chart shows that S&P Dow Jones Indexes usually gets the timing of its changes wrong. Furthermore, the ‘New Dow’ will be subject to the whims of the most vulnerable sector of the US economy.

Good-bye Hewlett-Packard, Bank of America, and Alcoa. Hello Nike, Goldman Sachs, and Visa.

The Dow Jones Industrial Average is undergoing its most dramatic facelift in a decade and will morph into a much more financial sector focused average. The changes will go into effect September 20, 2013.

I see the following risks short and long-term:

Short-term Reshuffling Risks

In recent years reshuffling components was followed by temporary corrections. The weekly DJIA chart below chronicles changes and the effect on the Dow since February 2008 (there was no change from November 2005 – February 2008).

The short-term performance immediately following the shuffle was generally negative, although the losses were limited. Long-term was in line with random.

Long-term Reshuffling Risks

S&P Dow Jones Indexes, a subsidy of McGraw-Hill (which is also the parent company of Standard & Poor’s and J.D. Power and Associates), dropped one financial name (BofA) from the mighty Dow and added two (Goldman Sachs and Visa).

But the exposure to financials is more significant than even the two for one swith suggests. Why?

The Dow Jones (NYSEArca: DIA) is a price-weighted gauge, that’s why it’s called an average not an index. Price-weighted simply means that the stock with the biggest price tag carries the most weight. Currently that’s IBM. At $190 a share IBM accounts for 9.43% of the DJIA and is the unquestioned VIP (Chevron, the ‘runner up,’ trades at $123).

Soon to be deleted Bank of America trades at $14.50 and accounts for 0.74% of the index (keep in mind that the index has only 30 components). That means that BAC would have to move 13 times as much as IBM to match IBM’s effect on the average.

Currently financials are the fifth biggest sector of the DJIA and account for only 11.39%. Here’s where it gets interesting:

Visa trades at $186 and Goldman Sachs at $165. The top three holdings of the Dow Jones will be IBM, Visa and Goldman Sachs. Based on a quick thumbnail assessment, financials will soon be the biggest sub-sector of the Dow with an allocation around 25%.

We shouldn’t forget that the Financial Select Sector SPDR ETF (NYSEArca: XLF) and SPDR S&P Bank ETF (NYSEArca: KBE) lost 85% from 2007 to 2009, significantly underperforming the S&P 500 (NYSEArca: SPY), which was down ‘only’ 57%.

So the heavy financial weighting of the Dow can be a negative.

In fact, former Treasury Secretary Hank Paulson mentioned in a guest contribution for a German finance and economy newspaper that he fears yet another financial ‘firestorm’ (firestorm is the term he used).

According to Paulson the financial sector is quite vulnerable. This article explains in detail the problem Paulson warns of: Hank Paulson Warns of Another Financial Crisis.

Simon Maierhofer is the publisher of the Profit Radar Report.

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Weekly ETF SPY: XLF – Ticks Away from New 48-Months High

The Financial Select Sector SPDR ETF (SPY) and entire financial sector are quietly closing in on a 48-month high. Buoyed by Bernanke, rising interest rate margins, and technicals, how high can financials fly?

It’s been a little while since we looked at the Financial Select Sector SPDR (XLF). The March 15, Weekly ETF SPY featured a long-term chart of XLF that showed a broad support/resistance range.

The daily XLF chart below includes the same support/resistance range (red bar). This range halted the XLF rally in March and April 2013 and proved support for the recent correction.

The fact that XLF didn’t drop below the ‘red box’ was one of the reasons I didn’t trust the latest correction. XLF found support where it should have.

As of today, XLF is just ticks away from eclipsing its May 22 high. A spike above would result in the highest reading since September 2008, 48 months ago.

Once the May 22 hurdle is cleared, there is no real resistance until the 50% Fibonacci retracement of the points lost from May 2007 to March 2009 at 22.

What is worrisome and can be indicative of a ‘last hurrah rally’ is the significant lag of RSI since its high watermark in September 2012 (red dot).

The last leg of the big XLF rally started when sentiment surrounding the financial sector reached a significant low (green dot). At that time, on August 5, 2013, the Profit Radar Report wrote:

“Financials account for 14.21% of the S&P 500, which makes them the second biggest sector of the S&P 500 (behind technology) and worth a closer look. The SPDR Financial Sector ETF (XLF) is butting up against minor trend line resistance at 14.90 and the previous June/July highs at 14.85.

Financials are currently under loved (who can blame investors). Of the $900 million invested in Rydex sector funds, only $18 million (2%) are allocated to financials.

With such negative sentiment a technical breakout (close above 14.90) could cause a quick spike in prices.”

A similar bullish sentiment extreme would be a welcome tell tale for a future selling opportunity. Perhaps we’ll see that closer to 22.

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Weekly ETF SPY: XLF – Running Into Resistance

Financials are the second most important industry sector of the S&P 500 Index. Right now the Financial Select Sector SPDR ETF (XLF) sports a curious correlation to an economic indicator, along with some directional clues.

Since 2007, the financial sector has tracked consumer sentiment closer than any other sector. The chart below plots the Financial Select Sector SPDR ETF (XLF) against the Thomson/Reuters University of Michigan Consumer Sentiment Index.

Consumers aren’t nearly as confident now as they were in 2007 and the financial sector is far away from its 2007 high.

The comparison between consumer sentiment and XLF is more of anecdotal than predictive value, but the chart of XLF does provide some technical nuggets.

XLF is now trading above Fibonacci resistance at 18.21. This Fibonacci level corresponds to a 38.2% retracement of the points lost from 2007 – 2009.

The move above Fibonacci resistance is bullish and resistance now becomes support.

However, a resistance level made up of several lows reached in 2000, 2002, and 2003 is immediately ahead at 18.52 – 19.66.

Financials, as with the rest of the market, have enjoyed an incredible run, but investors have come to love financials a bit too much.

Current sentiment towards financials is almost the polar opposite to what the Profit Radar Report noted on August 5, 2012:

Financials are currently under loved (who can blame investors). Of the $900 million invested in Rydex sector funds, only $18 million (2%) are allocated to financials. With such negative sentiment a technical breakout (close above 14.90) could cause a quick spike in prices.”

The combination of sentiment extremes and upcoming resistance suggests that some type of correction is not far away. However, the correction may be more on the shallow side. Watch Fibonacci and trend line support for more clues.

Why Financial Sector Earnings Are a Deceptive Farce

Because of a slew of earnings reports, this has been called “the week of truth” for the financial sector. However, a deeper look at the sector shows that big bank earnings reports are at best symbolic. One could even say that the whole ritual is utterly deceptive.

Earnings season is in full swing and most financial heavy weights are due to report this week.

Yahoo!Finance writes that: “It’s a make or break week for the financial sector with five of six of the nation’s largest banks (JPMorgan, Goldman Sachs, Citigroup, Bank of America, and Morgan Stanley) scheduled to report fourth-quarter earnings results” this week.

Earnings are directly related to stock market valuations, but big bank earnings releases are nothing more than a ritualistic farce. Why?

There’s no simple answer, but the next few minutes will be well worth your time. Warning! Knowledge about banks’ (corresponding ETF: SPDR S&P Bank ETF – KBE) accounting standards will result in loss of faith in the financial sector’s worth.

From Mark-to-Market to Mark-to-Make-Believe

There was a time when banks loved the Mark-to-Market accounting model, because it allowed them to showcase truly miraculous real time profits. By 2006/07 the financial sector accounted for over 40% of S&P 500 earnings.

Things changed in 2007/08. Mark-to market was unpopular with banks because it would have shown enormous real time losses. Bankers preferred to hide their balance sheets, along with the Federal Reserve and Congress too.

Bankers lobbied the Financial Accounting Standards Board (FASB) to change the fair market accounting rule – rule 157 – but the FASB resisted. Changing fair market or Mark-to-Market was a free pass that practically required no write-downs ever.

However, via the Emergency Economy Stabilization Act of 2008, Congress gave the SEC the authority to suspend Mark-to Market accounting. FASB rule 157 was suspended on April 2, 2009.

FASB 157 – What Does it Mean?

Since April 2, 2009, banks are basically free to value their toxic assets as they please. This example illustrates how the financial engineering formula works in real life.

Bank ABC holds mortgage-backed assets originally valued at $1,000. After running some proprietary and non-verifiable models the bank determines it will eventually sell the asset for $950. The loss, termed credit loss, is only $50.

However, because of MBS bad rep, the banks portfolio is currently worth only $500. The actual current value ($500) minus the credit loss ($50) is called noncredit loss ($450).

The $450 noncredit loss is recorded on the balance sheet under “comprehensive income,” but is not run through the income statement. Those losses don’t affect earnings, and are excluded from banks’ regulatory capital calculation.

Extreme Financials

The chart below (courtesy of Yardeni Research) illustrates the effect of financials. The worst recession since the Great Depression caused five quarters of extreme earnings contraction followed by eight quarters of extreme earnings growth (yearly growth rates were capped at +100% and -100% due to extreme values).

Was the miraculous earnings recovery due to a fundamentally strengthening financial sector (corresponding ETF: Select Sector Financial SPDR – XLF) or accounting tricks?

Financials at 22-Month High – What Does this Mean for The S&P 500?

Pssst, no one is talking about it, but one industry sector has quietly climbed to new 22-month highs – Financials. Will their run continue, how can you tell when it’s over and how will it affect the stock market?

The financial media can’t see the forest for the trees or the stairs for the cliff.

So much ink is being spilled reporting Obama’s and Boehner’s latest comments, hints and lunch menu, that the media missed the financial sector’s march to new 22-month highs.

Will financials continue to edge higher, and what does the financial sector strength mean for the S&P 500 and other broad market indexes?

The chart below provides a nutshell summary of the Financial Select Sector SPDR ETF (XLF).

1) Marks the technical breakout from a multi-week trading range. The Profit Radar Report expected this breakout on August 5, when it said:

“Financials are currently under loved. Of the $900 million invested in Rydex sector funds, only $18 million (2%) are allocated to financials. With such negative sentiment a technical breakout above 14.90 could cause a quick spike in prices.”

2) Shows that XLF never broke below the bold October 2011 trend line and never triggered a sell signal.

The strength in financials was one reason the Profit Radar Report maintained that the down side of the post September correction was limited and exited all short positions at S&P 1,348 and S&P 1,371 (and went long at S&P 1,424 last week).

3) Volume over the last couple of days has been solid.

4) RSI is lagging the September 14 high water mark and will be running into resistance. RSI may also set up a longer-term bearish divergence if it isn’t able to beat the September high.

XLF accounts for 15.42% of the broad SPDR S&P 500 ETF (SPY) and has the power to be the tail that wags the dog.

This price/RSI divergence in XLF might harmonize with my expectation for a large-scale market top sometime in Q1/Q2 2013.

There’s a newly formed support line (not shown in chart), which should be used as stop-loss for long positions.

No doubt by the time the media moves the spotlight on financials’ performance, the lion’s share of the gains will be already over.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.

P/E Ratio Based Valuations are Beyond Deceptive

P/E ratio analysis used to be a time-tested, go to valuation parameter. Recent changes however, have turned the P/E ratio into the most deceptive value barometer around. Here’s why.

The P/E ratio is based on profits and only reliable as long as the “P” in P/E are actual profits. In a world where Wall Street thrives on manipulation, do P/E ratios still apply?

To illustrate: Wells Fargo is trading around $33 a share with earnings per share of $3.18 and a P/E ratio of 10.40. This is cheap, isn’t it?

But how do we know that Wells Fargo’s profit is really $3.18 a share?

As of December 30, 2011, Wells Fargo had total assets of $1.313 trillion and total liabilities of $1.173 trillion. You and I don’t know what the assets and liabilities are, and I venture to say that Wells Fargo doesn’t even know.

How much are the millions of homes Wells Fargo financed before the housing bust really worth? Again, we don’t know, but we know that due to an FASB (Financial Accounting Standard Board) rule change, Wells Fargo and every other corporation in the U.S. can now overstate the value of their under water assets.

FASB Rule 157

FASB rule 157 applies to fair value (or mark-to-market) accounting. Fair value is (or used to be) defined as “the price that would be received to sell an asset or paid to transfer liability in an orderly transaction between market participants.”

In 2008 the market turned disorderly and on April 9, 2009, the FASB (strong armed by Congress) changed rule 157 to suspend the fair value rules when the market is unsteady.

Instead of reporting the current value of an asset (market-to-market), corporations are now allowed to pick a price they believe the asset will be worth in the future (mark-to-make-believe).

Cause and Effect

What effect would this have? A March 2009 Bloomberg published this assessment:

“By letting banks use internal models instead of market prices and allowing them to take into account the cash flow of securities, FASB’s change could boost bank industry earnings by 20 percent. Companies weighed down by mortgage-backed securities, such as New York-based Citigroup, could cut their losses by 50 percent to 70 percent, said Richard Dietrich, an accounting professor at Ohio State University in Columbus. ‘This could turn net losses into significant net gains,” Dietrich said.’”

Is that really what happened? Let’s see which companies drove earnings growth for the S&P 500 in 2012.

The chart and data below was compiled by Morgan Stanley’s Adam Parker. According to his research, ten stocks are driving about 88% of the entire S&P 500 earnings growth.

Six (seven if you consider GE a financial stock) of the ten companies belong to the financial sector (Bank of America, AIG, Goldman Sachs, Wells Fargo, JPMorgan Chase, Citigroup).

Without Apple and the financial sector, earnings growth for the S&P 500 would be next to zero. A bad year for Apple and a return to fair value accounting could easily double the P/E ratio.

Based on P/E ratios, does the S&P 500 still look cheap?

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.