Are Financial Stocks Setting Up for a Crash?

Submitted by BehindWallStreet as part of our contributors program.

As we’ve seen the market continue push higher, there are some new signs pointing to a possible loss of momentum.

When looking at a market such as the S&P 500, there are many components within it that can give indications about the true health of the index. Breaking things down and looking at the individual components can help illuminate what’s really happening beneath the surface.

This is the exchange-traded fund for the S&P 500, the SPDR (NYSE/SPY) administered by State Street Global Advisors. As you can see it is still near the highs of the year, which are also the all-time highs.

While the S&P 500 has continued to hit new highs, notice that the technical indicator MACD has actually been making lower highs throughout this time period. This divergence is telling me that the S&P 500 is beginning to lose momentum.

Overlaid on the chart is the Fibonacci retrace the levels, which point out several areas to watch for on any pullback. As always, the 200 day moving average (in red) is always important and it lines up quite well with the 38.2% Fibonacci retracement level.

Also notice that the 50% retracement level coincides with a support zone for the S&P 500 from March until late April of 2013. Following that, the next area to watch was also a support zone for the S&P 500 from late January until late February 2013.

How does the financial sector come into the conversation?

While the S&P 500 has recently made a new high, the financial sector has not. This is the exchange-traded fund that comprises of financial stocks, the SPDR Financial Select Sector (NYSE/XLF).

In response to a submission by a reader to our offer of free research, available here, we’re going to take a quick look at the SPDR Financial Select Sector (NYSE/XLF).

Notice that the technical indicator MACD has also continued to make lower highs even as the financial sector made a new high in July. With the recent failure by the XLF to make the recent high in September, this is a concern for me in that it indicates that the strength of the S&P 500 overall is beginning to weaken as one of the key pillars of the move up is faltering.

However, I want to emphasize that both the XLF and SPY are still in bull markets technically. For the XLF I would want to see a break below the $19 area before I would begin turning bearish on this sector.

Fundamentally, the financial sector has a lot to worry about.

While the Federal Reserve didn’t change its monetary policy stance yet, it’s only a matter of time before they do. That will be a significant turning point, especially for the financial sector.

While there are some positives in an adjustment to monetary policy, such as having a steeper yield curve that would benefit the financial sector, we will also have a large drop-off in mortgage origination and other large transactions that require financing, which is obviously a negative factor to consider.

On top of that is the increased scrutiny and regulation on the financial sector for the foreseeable future. Regulators are already looks at financial firms extremely closely, and I would certainly imagine having higher levels of regulation not lower over the next decade.

In addition we could see continued litigation against the financial firms for transgressions that have occurred over the past decade. J.P. Morgan Chase & Co. (NYSE/JPM) is currently in talks with regulators to settle many disputes, with estimates ranging up to $11 billion in total. If J.P. Morgan admits guilt in any of these cases, this could open the door for civil suits by former clients, possibly costing the firm even more money.

I’m not pointing out J.P. Morgan in particular, but simply stating that the hurdles for the financial sector are significant over the next few years.

When I consider how much bank stocks in general have appreciated in price over the past few years, I would definitely be inclined to take profits and avoiding the sector until many of these issues are settled.

For information regarding stocks we do like, check out our Flagship Newsletter.

This is a cursory look at both the SPY and the XLF and I’m not making any specific buy or sell recommendation but merely voicing my opinion of the current situation. Each individual investor must conduct their own due diligence of each company, the market sector as well as their own financial situation and risk parameters.

By Joel Laceda -October 2, 2013 BehindWallStreet.com