Arbeter: Keep Your Eye on Financial Stocks

S&P's technical strategist says the ability of issues in the beaten-down sector to hold their mid-August lows will be a key factor for the overall market

by Mark Arbeter From Standard & Poor's Equity Research

On October 19, 2007, the S&P 500 gave us a bit of indigestion, but nothing like the feeling we had 20 years ago on Black Monday, when we lost a good portion of the down payment on our first house. Fortunately, things worked out as they usually do.

The action on Friday, Oct. 19, was ugly as the S&P 500 dropped right through its 50-day exponential average at 1515. This is a bit concerning as the "500" many times bounces off the 50-day the first time it falls to it during an uptrend.

There is a big zone of chart support that runs from 1480 to 1520, from the mid-September breakout. The 65-day exponential and 80-day simple average sit down between 1500 and 1510. In addition, a 38.2% retracement of the rally since August is at 1505. We expect these pieces of support to hold before another rally begins.

Overall, the major indexes pulled back last week, after the market ran out of gas late in the preceding week. Many stocks and indexes seemed to fall back to near their 50-day moving averages, something that eventually happens after a major upside reversal. We think another piece of the pullback story, especially for the blue chip indexes like the S&P 500 and the Dow Jones industrial average, was that the financials have declined once again, and are testing their August lows. This was a given, in our view.

When an individual stock or index falls sharply over many months, it is very common to see major price tests of the ultimate low sometime down the road. We don't mean tests a week later, but months later. The size of the eventual base usually corresponds to the size and duration of the decline. When we look at the many pieces of the market today, it is odd to see so many stocks at new highs, while the financial stocks are still working on potential reversal formations.

We think one of the keys for the stock market in the near-to intermediate-term will be the ability of the financial sector to hold the mid-August lows and finally complete intermediate-term reversal formations. If financials break strongly to new lows, our call for a rally to the 1600 to 1650 for the S&P 500 may have to wait awhile.

One of the major banking indexes, the KBW Bank Index (BKX) is in the process of testing the lows from back in August. This index is made up of 24 banking stocks with large representations coming from J.P. Morgan (JPM) (9.1%), Bank of America (BAC) (8.4%), Wells Fargo (WFC) (8.1%), and Citigroup (C) (7.4%). The BKX peaked at 121.06 on Feb. 20, and then fell 16%, bottoming out at 101.60 on Aug. 15. So, in our view, a 6-month decline that encapsulates 16% on the downside will take time to reverse. Now with the index trading near the 102 level, we think we are in critical, full-blown retest mode.

The BKX did rally about 9% following the lows in August, but ran out of gas after retracing about 50% of the correction. This kind of initial retracement is fairly common after a major decline. The BKX also rallied right to major chart resistance near 111. It is also quite common for an initial rally from a potential intermediate-term bottom to run out of steam at the first piece of major chart resistance.

The S&P Financial SPDR (XLF) is another index we monitor and is somewhat similar in composition to the BKX. The XLF has more components but is market-cap weighted with major representation from Citigroup (8.4%), Bank of America (8.3%), American International Group (AIG) (6.4%), J.P. Morgan (6%), and Wells Fargo (4.3%). The XLF made a minor new high at the end of May and then proceeded to fall 16% into its initial low of 32.06 on Aug. 3. This area was tested very quickly on Aug. 15 and once again on Sept. 10. The Financial SPDR is back down in the 33 area after retracing about 61.