A Cooling Off For Fiery Financials

08/09/06 11:14:04 AM

by David Penn

Soaring financial stocks take a badly needed break.

Security: XLF
Position: N/A

There is no denying that Friday, August 4, was a reversal day. Any time you get a session that opens up and closes down after several sessions of advances, there's a good chance that you've found yourself a place to pause. This was perhaps most noticeable in the financials, one of the few, nonexplicitly defensive areas to be moving aggressively higher in the wake of the midsummer lows. See Figure 1.

FIGURE 1: S&P SELECT FINANCIAL SPDRs FUND, DAILY. A session like the one on August 4 that comes with a noticeable uptick in volume makes it likely that a pullback to near support is in the cards.

Graphic provided by: Prophet Financial, Inc.

But there are a number of ways for a market to pause or correct--and not all, or even most, of those ways involve portfolio-crushing crashes. In fact, one of the cleverest ways markets have of working off overbought conditions is just to move sideways. This sideways movement has the effect of wearing down both the psychology of weak holders as well as the time premiums of options. And both of those developments tend to bring prices back down to levels at which buyers again become interested.

Price action like we saw on August 4 also can have the effect of luring aggressive short-sellers into the market. Convinced that the bearish swing is not yet over, aggressive short-sellers look to sell every rally with the same gusto that aggressive long-side speculators look to buy every dip. Sideways movement is no less ruinous to these short-sellers. As their short positions remain on the books without profit and some on the short side begin to cover, the upside pressure of the short squeeze can be swift and powerful. And given that because the squeeze comes from sideways movement as opposed to a sharper correction, the level at which the squeeze begins tends to be higher and the pain for slower-moving short-coverers all the more acute.

FIGURE 2: S&P SELECT FINANCIAL SPDRs FUND, DAILY. A short-term negative stochastic divergence suggests that the upside is limited for financial stocks for the time being. But the "positivity" of the MACD histogram and the presence of support in the form of the 50-day EMA and the price congestion from early July both hint that the downside may be limited as well.

Graphic provided by: Prophet Financial, Inc.

My histochastic setup using the stochastic and moving average convergence/divergence (MACD) histogram (hence the name) provided for a short entry at about 32.79 (see Figure 2). I've written about this setup or method before. In this instance, the short is justified by the negative stochastic divergence. The specific entry is created by dividing the range of the point day (the session when both the histogram and the stochastic ticked downward after the divergence) and subtracting that quotient ("answer" to a division equation) from the session low. As of this writing, that point of 32.79 has yet to be hit.

I wouldn't be surprised if the trade is a loser if that point were hit. There is an abundance of support: the 10-day exponential moving average (EMA) in red, the 50-day EMA in blue, and the trading range from the first half of July all conspire to keep XLF from falling too far too soon. It is certainly possible for a wave of selling to take the financials lower, but it will have to be a sizable one--an ordinary, garden-variety loathing one, especially in the immediate wake of the Federal Reserve Board's decision not to raise short-term interest rates, is not likely to suffice.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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A Cooling Off For Fiery Financials

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