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What's With The Banks\?

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The S&P 500 (SPX.X) is a market weighted index of the largest 500 public companies. It's divided into 10 broad industry groups. Those groups are: Energy, Materials, Industrials, Consumer Discretionary, Consumer Staples, Health Care, Financials, Information Technology, Telecom Services, and Utilities.

The largest of the 10 industry groups, as measured by weighting, is Financials with a current weighting of 17.64 percent. The Information Technology and Health Care industry groups follow with each currently accounting for about 15.50 percent of the S&P 500.

The Financials group is comprised of 70 companies and includes a wide variety of institutions. Money Center banks, such as Citigroup (NYSE:C), insurers such as American International Group (NYSE:AIG), mortgage-related concerns such as Fannie Mae (NYSE:FNM), credit card issuers such as American Express (NYSE:AXP), brokers such as Morgan Stanley (NYSE:MWD), and regional banks such as Wells Fargo (NYSE:WFC) are all represented in the Financials industry group.

The Financials group is the most influential sector on the S&P 500 for an obvious reason: Its current over weighting. But, perhaps more importantly, is the Financials' indication of the health of the broader U.S. economy, specifically the banks.

The banks are the ones who extend credit to businesses for purposes of growth and expansion. But the banks have been extra tight with credit over the past six to nine months because of credit concerns - a product of debt-filled balance sheets and debt-ridden consumers and businesses. In addition, during the last boom, some banks ventured into the once lucrative capital markets businesses, such as trading, underwriting, and venture capital. Now that capital markets have dried up, many banks are suffering from a loss of revenue in addition to increasing defaults.

Just last week, U.S. Bancorp (NYSE:USB) lowered the bar due to "lower capital markets-related revenue" and announced that it would increase its provisions against loan losses to $1.03 billion. The stock sold off on the news, but the banks were weak prior to U.S. Bancorp's warning last Friday judging by the price action in the Bank Sector Index.

The Keefe, Bruyette & Woods (KBW) Bank Sector Index (BKX.X) is a broad measure of banking issues, which encompasses the large Money Centers such as Citi as well as smaller regionals and a few Savings & Loans (S&Ls). My colleague, Jeff Bailey, usually references the S&P Bank Sector Index (BIX.X) when addressing bank issues. The only difference between the BKX and BIX is that the former includes the Money Centers, which typically have greater international exposure.

The following quote sheet lists the current components of the BKX:

The BKX sold off last Thursday, during what appeared to be a large distribution day. Again on Friday, the BKX dropped in the wake of U.S. Bancorp's warning. But, the banks are weak again today (Monday). Maybe the word 'weak' doesn't properly represent the BKX's price action.

At the time of this writing, the BKX has retraced more than 50% of its rebound from the lows two weeks ago. As we saw in today's 9:00 a.m. Update, the S&P 500 has currently retraced about 19% of its recent rally. By this very rough comparison, it's easy to surmise that the BKX is out performing the broader market to the downside.

What's interesting is that the BKX had out performed the S&P 500 to the upside in early September. But that dynamic has obviously changed in the past three days. To get a better grasp on the BKX's price action relative to the S&P, we can turn to point & figure charting.

The BKX's price action plotted against the SPX's is currently quite interesting. So interesting, in fact, that the BKX appears to be heading for a sell signal on the relative strength chart, but it's not there yet. The BKX reversed into a column of 'Os' recently and is now two boxes away from giving a sell signal.

For the sell signal to be generated, the BKX has to print 733, which would put the index below its 61.8% retracement level.

We can come up with a handful of explanations for the banks' weakness recently. For starters, the price action in the BKX may reflect that the Fed is nearing the end of its benign monetary policy. After all, the end of an easing cycle is normally followed by a tightening cycle, whether it be six months or two years away. Also, one could argue that the economic rebound in the U.S. is farther away than previously expected.

But, instead of trying to surmise why the banks are weakening, we can try to come up with a few scenarios that are more actionable than subjective rationalizations.

The BKX could very well be the "head of the snake," as Jeff Bailey often writes. By that I mean that the BKX could be foretelling of a weakening in the broader markets, which already begun in the Dow Jones Industrial Average ($INDU) and S&P to a small extent. The BKX could be foreshadowing a "retest" of the lows put in two weeks ago, which would require other sectors of the market to follow the lead of the BKX, ultimately including tech sectors.

If the BKX's price action is foretelling of a "retest," it should be noted that such a pattern could come in many forms. For example, the BKX could rebound from its 61.8% retracement level and technicians would argue that that would be a "retest" in addition to a higher relative low and bode well for the broader market. Then again, the BKX could trade below the 700 level again and "retest" its relative lows, creating the double-bottom, which takes the shape of a 'W.'

Or, the BKX could take out the bottom that it put in two weeks ago, which could potentially signal weakness in the broader markets and bode poorly for the health of the U.S. economy. Whatever transpires in the BKX in the coming weeks, it's my sense that the index will lead the broader market, especially the S&P 500. If that's the case, then the BKX can be used as a reference when setting up trades in other sectors that might be lagging the BKX.

Eric Utley Option Investor

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