Thursday, October 18, 2007

Technical Thursdays: Long Story Still a Short

When a dominant sector of a bull market enters rough waters, some investors may be tempted to establish a contrarian long position. Case in point - Financials.

Such inclined investors might perceive that the current bad news for the Financials is close to fully discounted. After all, with the low point for Homebuilders, and thereby Financials, forecasted by certain prognosticators to be the spring of ’08, the requisite lead time of six months to an economic trough in the sectors seems plausible. Therefore, given the discounting mechanism of the market, the contrarian reasoning says now is the time to establish long positions. The advice from this contrarian’s desk is don’t do it.

The above chart shows the Financials sector firmly in the grip of a neutral to negative longer-term pattern as the very reliable moving averages principle indicates: Price below moving averages, 50 day below 200 day, both 50 and 200 day moving averages pointing south.*

It should be noted that in 2005, XLF produced a somewhat similar neutral to negative moving averages signal. So, perhaps the same will occur this time. However, as with most technical indicators, it is far better to wait until a clear cut signal is made and pay a few percent more than to anticipate a reversal of an established pattern.

Investment Strategy Implications

There’s a time when being a contrarian makes sense. From a technical perspective, when it comes to Financials this is not that time.

*See prior Technical Thursdays entries for more info and examples re the moving averages principle.
To view a larger version of the above chart, click on the image.

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