Arbeter: Time to Head for the Hills?

S&P's technical strategist says action in financial-sector indexes and bond yields has serious implications for the overall stock market

From Standard & Poor's Equity Research

We thought we had a selling capitulation in the financial sector two weeks ago. Guess again. Last week it was Citigroup (C). No matter who it is this week, the financial indexes and bond yields that we have been talking about are breaking the wrong way, and we think this has serious implications for the overall stock market. We see this as a good time to head for the hills for awhile and enjoy the refreshing fall weather and clear our head of all these crosscurrents. It feels like we are at a crossroad and there are signs pointing in 10 different directions. Then again, no one said predicting the future would be easy.

The S&P Financial SPDR (XLF) broke down on Friday, Nov. 2, as the recent closing low of 32 could no longer hold. This is the lowest close for the XLF since July 2006. With the break of support at 32, the index is susceptible to losses to the next layer of chart support down in the 27 to 30 range. This support is from a price consolidation from back in 2004 and 2005. The 50-day exponential average is below the 200-day exponential average, a bearish crossover, and both averages are declining. More importantly, the 17-week is below the 43-week average, suggesting the index has entered a bear market.

The KBW Bank Index (BKX) fell sharply last week, breaking to a new closing low. This index has actually been weaker than the XLF, as it fell to new lows during the middle of October, before meekly recovering major chart support around the 100 area. There was no doubt about it on Thursday, Nov. 1, however, when the index plunged 5.36%, its worst one-day decline since September, 2002. With the 2% loss on Friday, the index is now down 21% from its February high. The next major chart support for the BKX is in the 93 area.

The 10-year Treasury yield looks like it is hanging on by a thread, as it once again tests the important 4.3% level. On Friday, the yield dropped to 4.28% on an intraday basis but rose from there to finish right at important resistance. We believe that with the breakdown in the financials and the appearance that bond yields will follow, it will be very difficult for the overall market to make much headway, and we think that a wide trading range is the most optimistic forecast at this time. We also think that with sentiment having gotten so rosy, that we could eventually see an 8% to 12% correction in the intermediate term.

Market speculation can come in many forms and affect many different markets. We were surprised, after the beating the market took this summer, that bullish sentiment would rise so quickly and strongly. Sometimes sentiment moves in a slow, grinding process, and other times investors seem to turn on a dime. Not all of the sentiment indicators we monitor are showing extreme optimism, unfortunately, the majority are with some that measure what the individual is doing moving quickly into the "get me in at all costs" camp. Many times, this is when it is dangerous to be overweight equities.

The ISEE sentiment index jumped to 191 on Oct. 29, the highest reading since August, 2006. During the correction this summer, this index got as low as 51. This index is a call/put ratio based on opening trades by individuals. Recently, it has shown that individuals are rushing to buy calls relative to puts, a sure sign of bullish speculation. The most recent high for this index was at 187 on October 8, right before the slide into the middle of October. Prior to that, the index peaked at 186 and 181 during the early part of July, right before the downdraft last summer.

A second indicator we like to use to measure speculation in the marketplace is the ratio of Nasdaq volume to NYSE volume. The 3-week average of Nasdaq volume to NYSE volume hit 163% on October 19, the highest level during a bull market since early 2000. Prior highs during the current bull market ranged from 136% to 158%. Following each of these speculative readings, the market had a pullback or correction in the next four to eight weeks.