Financials Break To The Upside And That's Good For The Market
- The head and shoulders that did not “work”
- Inflation versus deflation sectors
- Which are the financial sector stars?
- Why financials matter
The head and shoulders that did not “work”
On this same date in May we published an article suggesting that financials could be an interesting area to monitor for a potential break, either to the upside or downside. Specifically, we were looking for a downside move below the red trendline at $23 on the XLF, because that marked the neckline of a potential top. The other benchmark lay above the green down trendline, because that one joined the head with the extreme right hand shoulder. Usually a move above the head/right shoulder line is enough to confirm the failure of the head and shoulders top. I say “usually” because technical analysis deals in probabilities. I can’t prove it but such a break raises those odds in my opinion to something like a 60% level of confidence. The odds get even higher, if the price surpasses the level of the right shoulder, which in this case is $24.
Note that this breakout is being supported by momentum as the daily KST, in the lower window, has just gone bullish. When a head and shoulders pattern fails, it is usually followed by an above average move. That’s because traders position themselves on the short side in anticipation of the pattern’s completion. However, when the break fails to materialize they are forced to cover and compete for available stock with those who have been bullish all along, as they continue to accumulate. This combination of new buying and panicked shorts scrambling to cover, often results in a sharp advance. I am not saying that’s going to happen in this case, but you never know!
Chart 1
Chart 2 shows the same period for XLF, but this time featuring a line chart. Looked at in this way, you can see that the post March price action represents a reverse head and shoulders, with a Thursday breakout. The Price Volume Oscillator (PVO) in the lower panel, often gives buy and sell signals when it is possible to construct a trendline, whose violation is confirmed by price. We see two previous examples, one bullish and the other bearish, where a downside break was accompanied by expanding volume. Now the technical position is setting up the potential for a third, as the oscillator is very close to confirming the price breakout. If that happens, the probabilities that the breakout is for real would be substantially increased.
Chart 2
In recent years financials have been influenced by swings in interest rates, since higher rates morph into higher margins and therefore profits and vice versa. Chart 3 compares the XLF to the 10-year bond yield, the $TNX. Both series rallied last fall, moved sideways for a while, and started to diverge in May, with financials rallying and yields falling, as flagged by the dashed blue arrows. Assuming that this relationship still holds, I would expect to see the 10-year series rally along with the XLF.
Chart 3
Chart 4 shows that the relative action in the centre panel has started to perk up for XLF with a tentative break above the green down trendline. The KST for relative action is not yet bullish but should turn, given the loss of downside momentum implied by the trendline break.
Chart 4
To complete the bullish picture then, we need to see a break above that right shoulder at $24 on the XLF, a pick up in volume, and a more decisive breakout in relative action, so far Friday’s action is confirming most of this.
Chart 5 tells us why the health of financials is important for the health of the overall market. In this respect, the green shaded areas point out when the long-term KST for financial relative action is rising. In pretty well all situations the S&P Composite rallies. Right now, the KST is flattening, which means that this week’s breakout is so important. If it holds, as I expect, then this should power both the KST and the market higher.
Chart 5
Which are the financial sector stars?
If a sector is going to prosper it’s usually possible to observe some leading characteristics in the form of some sub-industry groups. In that respect, Chart 6 shows that the US Broker Dealers, the IAI, seem to be ahead of the pack with clear-cut breakout on both an absolute and relative basis. The reason why this is positive lies in the fact that stocks lead the economy but brokers have a tendency to lead the market. That’s because they do more business when equity prices are rising, as profitable traders tend to trade more and higher prices attract more lucrative IPO’s.
Chart 6
Another financial leader is the Spider Capital Markets ETF, the KCE, as shown in Chart 7. This one has strong relative price and momentum action. On an absolute price basis it is very close to a new high.
Chart 7
Inflation versus deflation sectors
Chart 8 compares the CRB Composite ($CRB) to the ratio between inflation and deflation sensitive equities. The dashed arrows indicate that the equity market ratio often leads the commodity markets as investors are generally quicker to change their inflation/deflation bets than those in the commodity pits. The solid red arrow in 2008 tells us that this is not always so. Both series reached a major bottom in early 2016, so there was no leadership role at that time. However, the mid-2016 rally high was touched first of all by the ratio. The CRB followed in early 2017. Currently, both series are in a down trend and are confined below their respective solid declining trendlines, suggesting the possibility that they are tracing out a downward sloping head and shoulders. Three sets of previous joint trendline breaks were all followed by strong moves, which means that if these two potential necklines are penetrated a worthwhile inflationary move would follow. In the meantime, none of this is proven, so I am treating the current trend as deflationary.
Chart 8
Good luck and good charting,
Martin J. Pring
The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group of Walnut Creek or its affiliates.
