Five Reasons Why Financials, and Stocks, are Breaking Out

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The most favored chart pattern for all investors is the base pattern. A base is formed when a stock has declined for a period of time and then trades sideways while long-term moving averages flatten out. When the stock breaks out above resistance and the long-term moving averages begin to rise, that is the moment you usually pounce.

Right now, there are countless basing patterns in housing, financials, materials, and energy. While no materials and a few energy stocks have broken out, many housing and financials have already or are in the process of doing so. With many of the banking problems looming globally, many investors are wondering why financials are now the best performing sector year-to-date.

Aside from a number of important catalysts that I'll outline below, as I explained in my article of August of last year, “Sector Rotation at Mach Speed”, financials were simply the next logical sector to outperform based on a business cycle perspective. Tracking the relative performance of various sectors as they rotate through the business cycle is an extremely important investment tool as, shown in the following chart, starting late November of last year, financials predictably broke from their multi-month basing pattern and now show outperformance versus the S&P 500 over that time. 

financial outperformance

I remember a meeting with Jim Puplava in the Fall of 2008 during the financial crisis. Lehman, Merrill Lynch, Countrywide, and Bear Sterns were some of the names of financial institutions that went under or merged into larger entities at the time. I can remember telling Jim, “This is a bear market in financials, but eventually, there will be a time that we need to own them. We can’t stay biased and married to the idea of never owning financials due to the housing bubble, because bear markets don’t last forever.”

We had been warning our clients in newsletters, our readers on Financial Sense Online, and listeners to the Financial Sense Newshour of the housing bubble in 2005 and 2006 when it peaked. Jim even wrote a fictional series in 2005 called the “Day after Tomorrow” highlighting the Wheelers and the excessiveness of financial leverage in housing and the unintended consequences of a low interest rate environment. Jim called it the brewing of the perfect financial storm, long before any CNBC reporter used the phrase in 2008.

This is to say that we avoided financials and housing stocks like the plague. Housing stocks peaked in mid-2005 so we didn’t think we missed out by avoiding the group. Most financials didn’t peak until the market did in mid-2007, but we didn’t miss out much there either. They had risen, on average, about 10% since mid-2005 but still looked terrible from a macro and technical perspective. 

So how do financials look now technically? Currently, the XLF S&P select Financial SPDR Fund is up 20.6% year-to-date with a major base breakout pattern in January. Click on the chart below where I highlight the most important technical developments.

xlf 15 March 2012
Source: StockCharts.com

Financials are overbought now, but you can see clearly that they are now in an uptrend after forming a major 5-month bottom. You may be asking yourself, why are financials going up? What are the catalysts and reasons I should own any financials? Let’s now talk about some of those catalysts.

I. The Economy Is Doing Better

ECRI’s weekly leading economic indicator index has been rising since September 2011, interestingly the moment they called a recession signal. Now, Achuthan ignores talking about his leading indicator index and only refers to the lagging coincident index. Although the smoothed annual growth rate is still negative, the rate has turned up rather quickly from negative 10.1% in late October to negative 2.6% recently. Other recent data, like the jobs report over the past three months, also supports the idea the economy is doing better. The average over the past three months has been an addition of 244,000 jobs while the average monthly increase was 153,000 in 2011. Besides the government’s employment numbers, here are a few more economic indicators to consider – many of which were championed by deflationists in 2008. As you'll see below, the consumer is a tailwind to the economy again.

The ECRI’s Weekly Leading Index

ecri wli

Source: www.economy.com/dismal

Growth in retail sales since 2009

retail sales growth

Source: www.economy.com/dismal

Consumer Credit Expanding Again

consumer credit expanding 

Source: www.economy.com/dismal

II. Housing Is Improving

One of the biggest negative catalysts to owning financials was the housing bubble from 2003-2006. At the end of 2006, the FDIC showed $11.8 trillion in total assets, $4.5 trillion of which were real estate loans. At the end of 2011, total assets are now $13.8 trillion and real estate’s pie has shrunk to $4.1 trillion. You can find the FDIC data here. While banks have clearly diversified, and their assets have shrunk in real estate due to foreclosures and falling prices, housing is still a major driver in quantifying the health of financials. So how is housing doing?

According to the National Association of Home Builders (NAHB), sales are increasing, traffic of potential buyers is increasing (up twice as much as in September), and builder confidence has increased. Are we out of the greatest housing recession in the baby boomer’s lifetime? No. Not yet. According to the Mortgage Bankers Association (MBA), the number of people looking to purchase a home has fallen over the last year even though construction spending is up 5% from a year ago (ending 2011).

NAHB housing market index up five consecutive months

nahb housing market index
Source: www.economy.com/dismal

Construction spending turning up

construction spending

Source: www.economy.com/dismal

III. $25 Billion Mortgage Settlement

Bank of America, Wells Fargo, Citigroup, JP Morgan, and Ally Financial reached a $25 billion agreement with the federal government and 49 State Attorney Generals to settle a civil dispute over the banks’ foreclosure practices. With this suit ongoing for the past couple of years, banks have recorded reserves against this exposure. In the short-run, we don’t really know how much exposure each bank has to the settlement nor how much they’ve reserved for it, but the long-run effects can be deciphered. Now that servicers have clearer guidelines, foreclosure processing should pick up again in the short-term, but by next year, foreclosures should be less of an issue with Zero Interest Rate Policy (ZIRP) and an improving economy.

As far as Wall Street is concerned, this was an uncertainty looming over financial stocks. Investors do not like what they can’t quantify. Now that the lawsuit is out of the way, that’s one less thing for investors to worry about; however, the settlement doesn’t protect the banks from securitization-related litigation or claims by borrowers.

IV. 15 of the 19 largest banks Pass the Test

Bank Stress test results came out on Tuesday. The Federal Reserve had financial institutions run a scenario should they suffer from a financial crisis. In the scenario, they modeled unemployment hitting 13 percent and a 21% drop in housing prices. Fifteen of the largest banks passed the stress test threshold with four failing; although, only Ally Financial really “failed”. Regulators wanted to see that the tests would satisfy tier 1 common capital ratios above 5%. The four that failed were Metlife (5.1%), Citigroup (4.9%), Sun Trust (4.8%), and Ally Financial (2%). Bank of New York Mellon (13%), State Street Corp (12.5%), and American Express (10.8%) were the top scorers of the test.

Wall Street was worried about anybody that might fail, so cash has been on the sidelines until the news passed. The other issue is that now banks can consider dividend increases or stock buyback programs. Many of those programs were announced this week. That’s a tangible catalyst investors can hold in their hand.

V. Other Bank Businesses Are Returning To Health

The minute Citigroup said they had been operating at a profit through the first two months of the year in March of 2009, the market bottomed. The FDIC report for quarter end of 2011 showed that bank quarterly net income posted its tenth consecutive year-over-year gain based on lower provisions for loan losses. Banks set aside $19.5 billion in provisions for loan losses in the fourth quarter 2011. Provisions were 12.1% of net operating revenue, down from the peak at 51.7% in the fourth quarter 2008. Provisions for loan losses is an expense set aside as an allowance for bad loans. Falling expenses mean more profits.

The Negative Catalysts

The setting isn’t completely goldilocks for banks. Operating revenues have fallen. Both net interest income and noninterest income were lower in 2011 than in 2010. This is the second time since 1938 (including 2008) where this was so. In a ZIRP world, low-yielding balances with Federal Reserve Banks don’t help interest income. Trust operations and trading income were higher in 2011, by $3.8 billion total, but areas of weakness in servicing income, reduced gains on loan sales, and lower income from service charges on deposit accounts more than offset these gains.

The other issue is the Volcker Rule, a part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This prohibits proprietary trading and the investing in a hedge fund or private equity fund. Marketable Securities on the balance sheet of banks was $2.85 trillion at the end of 2011. The banks have stated this rule will hamper the competitiveness of American Banks. It will definitely hamper profits.

The final negative catalyst is the possibility of the global economy rolling over into a recession. Europe and China have both shown contractionary conditions in the purchasing manager’s index last week, narrowly. If conditions don’t stabilize and these economies roll over, it is likely they will pull the U.S. with them. I don’t think this is likely considering monetary policy in each region. Falling CPI numbers for China will allow the PBOC to lower bank reserve requirements (two cuts so far since December) and the easy money spigots have been opened full blast from the ECB since August 2011 to combat the sovereign debt crisis.

Other Bases

As I mentioned, there are other sectors that are basing. Basic material stocks have been since October 2011 and haven’t broken out yet. This is an area to keep your eye on. Steel stocks have been ticking up since last week. Coal stocks got a nice lift today, many of which are still near the price levels they saw in October last year. Careful buying these areas now, they haven’t broken out of their bases yet. The risk is low however, if you buy with a tight stop below the October 2011 lows. If the U.S. economy is improving and the rest of the world follows, we should see basic materials rebound.

As I mentioned two weeks ago, many technology stocks have created multi-year bases since the tech bubble burst in 2000. On a monthly-basis the NASDAQ itself has broken out of a major base. Louise Yamada is calling this the beginning of a new bull market in technology. Do me the favor and look at a 15-year monthly chart of Intel, EMC Corp, Cisco Systems, and Texas Instruments to see what I mean.

The base pattern is the pattern investors need to be on the lookout for. It suggests that a lot of the headwinds creating the previous decline in the stock are no longer relevant or a catalyst for future declines. When a stock breaks out of a base, it suggests new buyers are entering in. It also suggests there may be some catalysts propelling new and higher valuation metrics. If those catalysts are sustainable, a new, positive trend can develop, lifting the price of a stock up, up, and away from its base. This is the chart pattern investors should be looking for. Many of those patterns can be seen in the daily charts of energy and materials stocks. Many basing patterns can be seen in financials, housing, and technology stocks in the weekly and monthly charts. The current stock environment is full of breakout candidates and positively trending stocks, right as retail investors continue to pour their money into bonds due to bad stock performance in 2011. This is why I still like stocks for the next quarter or two, even at 1402 on the S&P 500. The bond bubble will burst someday and this money will have to go somewhere. My money is on stocks and commodities.

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About Ryan Puplava CMT

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