Could the S&P Go Higher Without the Financials Participating?

Posted August 10th, 2010 by Josip Causic in Education

Could the S&P Go Higher Without the Financials Participating?

In this article, I will discuss whether the U.S. market can continue going higher when its biggest component, the financials, are approaching supply. At one point during the roaring real estate market deals of 2004 and 2005, the S&P 500 had 25% of its components made up of financials. As the stock market peaked in July (and October) 2007 and started to head lower, the appetite for risk had decreased, and the allocation of the financials in the S&P had started dropping significantly. In early 2009, specifically the first quarter, only 9% of the S&P was represented by financials. The current composition of financials is back to double digits, specifically 14%. The latest change of sector allocation can be easily verified by going to the Yahoo Finance page and checking the holdings of SPY (Exchange Traded Fund that tracks the S&P 500). I have included the figure below as a visual.

Since the financials are the largest component of the S&P, let us proceed to the charts to verify whether the financials are technically strong As an option trader, I tend to use XLF (Financial Sector SPDR) due to its high liquidity and the fact that recently, weekly options have been issued on the XLF. I have discussed the phenomena of the new weekly options in my previous articles.

However, there are also at least two other instruments that I use for tracking the financials, though I do not necessarily trade them. They are XBD (AMEX Securities Broker/Dealer) and BKX (Philadelphia KBW Bank Index). For each of these two issues, it is easy to look up the components. Figure 2 shows just the first few alphabetically listed components of XBD.

More importantly, let us examine the charts of these issues as well as one bank stock to conclude what the financials are doing technically. Figure 3 below lists clockwise, starting on the upper right, the following tickers: XBD (top right corner), XLF, BKX, and WFC (Wells Fargo & Company). For the sake of uniformity, I have used grey rectangles to mark areas of supply and demand. Besides these support and resistance levels, I have utilized diagonal trend lines. The green ones represent bullish support, while the dark red represent bearish resistance. All four charts were simultaneously creating respective symmetrical triangles. During symmetrical triangle creation, it is not certain which direction the price action might break out: Up or down.

The XBD (top right corner) and XLF had broken above the diagonal bearish resistance (dark red line) as early as July 23, while the Banking Index and Wells Fargo took an extra day to catch up with the leaders. By the way, within the financials (XLF), there are various sectors or industries such as Insurance, Broker/Dealers and Banks. Within each of those industries, there are subgroups. Figure 4 shows that WFC not only belongs to the Financial Sector, but also specifically to the Industry: Money Center Banks.

The XLF, or the financials, were led higher not by the banks, but first by the Broker/Dealers. This is evident in the four charts in Figure 3. To make this more obvious, I have circled the break outs on each of the four charts with bright yellow ovals.
Nevertheless, I wish to call to your attention to this point - that just because the financials, with their respective sectors, have moved out of the symmetrical triangle, as did the broad market, how much more room to the upside do they have? Observe on the charts of Figure 3 that each of the four issues are approaching their levels of supply. This may very well occur before this article is published. If that happens, then I would expect them to turn down from there, which may very well prevent the rest of the market from going higher. In which case as option traders, we should check the current implied volatility and choose the appropriate option strategy.

In conclusion, will the U.S. market continue higher? The above visual answer in the charts is more persuasive than any written words. With the largest holdings of the S&P, the financials, approaching supply, I expect it may be difficult for the U.S. market to continue going higher. Get good at technical analysis and have green trading.

- Josip Causic

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