Thursday, April 3, 2008

Financials in the Larger Context

To elaborate on my Tuesday BNN TV interview and to provide a technical analysis perspective as to why the Financials are a value trap for investors, here are a few thoughts.

As stated in the interview, from a fundamental perspective any sector that is about to undergo regulatory change is by itself sufficient reason for longer-term investment pause. And in a highly charged election year, this risk becomes of greater concern. However, it is longer-term consequences of a changed business model that is the greatest risk to investing in the sector. For example, the specific risks to the Financials sector pales in comparison to the likely impact that a changed business model will have on the US and global economies - and then in turn back to the sector.

There is a larger economic consequence to the changed business model, one that few seem to be focusing on – the effect that a deleveraged, changed business model will have on credit creation. If the global economy was aided and abetted in the recent years by financial innovation, it is logical to assume that a dramatic (radical?) shift away from that business model of easy credit and financial innovation (securitization, for example) will result in a lessened degree of capital for consumers and businesses. Therefore, economic activity, particularly domestic activity in the US, will ratchet downward, influenced also by the need for US consumers to rebuild their depleted personal balance sheets.

As this relates specifically to financial institutions, the risk of competition (financial institutions in other regions of the world less burdened by regulatory constraints) due to a changed US regulatory environment for US financial institutions will also almost certainly create growth and profitability difficulties in the years ahead.

While all this real economy stuff gets absorbed by fundamentally-oriented investors, the technicals of the market may paint a different picture. It does not, as the two charts** above show.

The first chart provides a longer-term picture of the sector, which plainly shows a sector that is solidly in a negative mega trend, based on my Moving Averages Principle*. The second short-term chart provides a few reasons why the near term trend is modestly positive. Specifically, momentum and MACD are both positive. And the slow stochastic is not in high overbought territory (above 80 for both trend lines). Moreover, both MACD and the slow stochastic lines have not crossed, which would indicate the end of the near term uptrend.

Investment Strategy Implications

As stated on Tuesday, Financials should participate in the current spring rally. However, beyond this point in time, it is hard to conceive of the longer-term investment case for a sector undergoing a change to the core of its business model. As noted above, the technicals also reflect this longer term concern.

*See prior blog entries and reports for definitions and examples
**click images to enlarge


NewstraderFX said...

Your XLF chart reveals the most significant indicator available-the Double Stochastic.

In this case, a Double Stochastic OverSold was made, which signals an uptrend was highly likely to occur, wich is exactly what happened.

NewstraderFX said...

The XLF established a Double Stochastic OverSold (DSOS) between March 10 and March 31, which was followed by the April 1 rally. As shown in the ratio below, March 10 could very well turn out to be the market's bottom because in proportional terms, the housing/credit bubble has corrected exactly as the tech bubble before it.

The Market May Have Fully Corrected Already

The tech bubble caused the S&P to gain 234.5% (11/30/94 to 8/31/2000). The subsequent peak to trough crash was 46.28% (8/31/2000 to 9/30/2002). The housing bubble this decade caused the market to gain 90% from September 2002 to October 31, 2007 before the fall really began in earnest. How much will it fall now? Making an equation using a gain-to-loss percentage ratio established in the tech boom and bust has turned out to be very useful in predicting the overall S&P movement during the present housing and credit crisis.

234.5/46.28 = 90/x

Solving for x, we get 17.76 (nice and patriotic). That's the percentage loss we would expect to see this time, based on the ratio established in the tech boom/bust cycle. The S&P established the first of three Double Stochastic Over Bought indications on October 31 at 1549.36, which is where the plunge really began in earnest. Subtracting 17.76% from there, we get an expected fall to 1274.19. The closing price on March 10 was 1273.35. This is the established market bottom, the lowest closing price during the housing and credit bust, almost the exact 17.76% decrease predicted by the ratio established in the tech boom/bust cycle!