The Banks Must Hold From Here

02/26/09 9:00 AM EST

Good Thursday morning...We begin the day with some buying interest in the pre-market futures.  Despite pathetic economic releases this morning, and even more wretched results from GM, the pre-market gains have held.  Rising stocks in the face of bad news could trigger a "can't get them down" reaction into the end of the month.

Many traders, myself included, have been looking for some signs of stabilization among the financial sector.  That is ground zero for the crisis of confidence we're suffering through, and some basis of support there would seem to lend some to the broader market as well.

The past couple of days have been encouraging, as the BKX Banking Index rose more than 10% on Tuesday, then managed to follow through with an additional gain of more than 2% yesterday.

We've seen this kind of jump-then-follow-through before, several times.  And based on the chart below of those previous occurrences, we'd better see a sea change in behavior quickly, or we're in for some pain.

Over the next 7 sessions, the previous instances led to a return in the BKX of -15.7% on average, with an average maximum risk (-22.5%) that was nearly five times greater than the average maximum reward (+4.7%) during those 7-day trades.

The good news, I suppose, is that we should find out relatively quickly if we're on the cusp of yet another miserable failure.  The BKX topped out in short order after the other occurrences, within 4 trading days each time.  Three of them topped out the very day of the +2% gain.

The conclusion seems pretty clear - if we can manage to last into the end of next week without violating yesterday's low in the BKX, then we'll have likely seen a change in character from what we've experienced previously during this bear market.  And a change in character from the banking sector can only be good news for the rest of the market at this point.

It's also not exactly encouraging that while the BKX has out-performed the S&P 500 for each of the past four days, the other times we've seen this during the bear market have led to an average return in the S&P over the following week of -2.3%.  Only 2 out of 13 of the days led to a positive return, and the average maximum risk (-4.3%) was four times greater than the average maximum reward (+1.1%).

So it seems like we're at or very close to another moment of truth here.  The sign of stabilization in banks, at least as determined by a rise in their share prices over the past couple of days, seems encouraging, but we'd better have a clear grasp of recent history, and that history ain't pretty.  If we slip below yesterday's lows in the BKX and S&P, then it'll look more and more like we're just slipping into the same pattern of heavy selling and ultimately new lows.

Bottom line - Intermediate-term

We went over several studies in December (here and here and here) indicating that what we witnessed during November marked a major bottom.  But after what we went through to begin the New Year (e.g. the spike in Dumb Money Confidence and Intermediate-term Indicator Score, the failed breakout at 920 on the S&P, the subsequent losses of support at 880 and 850, and the failure to bounce off short-term oversold conditions), that probability diminished substantially.

Because of that January failure, I had been leery of buying into weakness until we either saw more of a pessimistic extreme in the Dumb Money, or an improved technical picture.  The Dumb Money is getting there with a current reading of 25% - low enough to be considered historically extreme - but that still doesn't approach the previous pessimistic extremes under 17% that we saw at each of the prior temporary lows since 2007.  That doesn't mean we can't rally, it just means that it's more difficult to define the probability of doing so.

As for the technical picture, the S&P 500 broke under the 800 area that had been support, and it's now hanging by a thread at the November lows.  Given the AAII data mentioned last week and a few other potential positives (now including the 90% Up Volume session from Tuesday), I can't outright dismiss the potential of a meaningful low forming at any point.  The tough part is that without an extreme in the Dumb Money and the murky technical picture, I can't find a decent risk/reward scenario for supporting a longer-term trade at this point and would expect any rally emanating from these levels to be turned back near probable resistance at 800 - 830 for now.

Bottom line - Short-term

Yesterday's session was brutally volatile, not helped in the least by pronouncements from the government, which just so happened to coincide with the major intraday peaks in stocks.

On Tuesday morning we went over several reasons to expect positive returns over the coming week.  After the big rally on Tuesday, we discussed a few more reasons to expect another 2 to 4 days of upside follow-through.  It got hairy there for awhile yesterday, but at least we hit a higher intraday high and have a chance to continue the short-term rally.

The chart below highlights what I think is most likely for the coming sessions. 

I'll be looking for a breakout over 780ish (using the e-mini futures, the levels aren't that much different for the cash S&P 500 index) to trigger the pattern.  If that happens this week, then we'd likely be overbought and subject to at least a temporary pullback.  Ideally that would hold above the breakout level, then lead to a final push to 820ish during the first couple of sessions in March.

If we hold this +1% gap this morning, and hit a higher intraday high after the first hour of trading, particularly if that is above yesterday's high of 780ish, then we should have a very good chance of closing well, and a significantly reduced chance of a failure later in the day.

I continue to think that a rally emanating from here will run into trouble between 800 - 830, and don't expect it to travel much further.  If it does, then I'd have to re-adjust the probability that we've already seen a major intermediate-term low.

If we fail here, particularly from today's indicated gap up opening, and trade under 750ish, then I would be abandoning the thoughts from the chart above.  Doesn't mean it couldn't still happen, but the pattern I'm looking at would be violated and I wouldn't necessarily be using it as a guide.

All the best,