Arbeter: Keep Your Eye on Financial Stocks

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From Standard & Poor's Equity Research

8% of the correction. In addition, the XLF ran into chart resistance in the 36 zone.

We believe that for the overall health of the stock market, it will be very important for the XLF to successfully test the 32 - 33 price zone, and then rally and complete an intermediate-term bottom.

With the decline and retest from the financial stocks, we are also seeing some yield testing by the Treasury bond market on worries over the economy. We view this simultaneous testing by financial stocks and Treasury yields as a function of anxiety towards the economy, and, therefore, as fear rises about economic growth, financials fall along with bond yields. The markets are basically mirroring each other. The initial yield low for the 10-year Treasury note was at 4.32% on Sept. 10. Yields then retraced 38.2% of the decline since June and are back down in the 4.40% area. We had said in prior comments that we expected some type of base or reversal formation before yields start to head higher in a more regular fashion, and that is what we continue to see.

However, like the financials, we think it is important that the 10-year holds near the recent yield lows, and starts to head higher. If yields break strongly below 4.3%, we then will have to question our bullish outlook for stocks, and we think many will question their modestly positive outlook for the economy.

We went through a slew of sentiment indicators in our last comment that suggested the bullish camp was getting crowded, but thought that because many of these indicators many times precede intermediate-term tops by a month or two, that the current advance was not yet complete. We got further confirmation last week that the bullish side of the fence was running out of room as we continue to see some real sentiment extremes. Bullish sentiment on the Investor's Intelligence (II) poll reached 62% last week, the highest reading since January, 2005, and one of the highest readings in the history of the data. The high level of bulls has only been exceeded by two straight weeks at the end of 2004/beginning of 2005, when analyzing the survey all the way back to 1987.

Bearish sentiment on the II poll is down to 19.6%, the lowest since July, and also at an extreme in our view. Intuitively, we think one would believe this kind of bullish euphoria on any market poll would be the death knell for equities. Fortunately, this poll has not been great at predicting market tops, but does suggest that the majority of gains for the current run are most likely behind us.

Arbeter, a chartered market technician, is chief technical strategist for Standard & Poor's .