Financial Sector Leads Broader Stock Market

02/25/09 10:08:03 AM

by Alan R. Northam

There are many ways to determine if the stock market is at or near a major market bottom. One way is by looking at the financial sector. Turns in the financial sector normally lead turns in the broader stock market.

Security: XLF
Position: N/A

Before the stock market can make a significant recovery, at least three things need to occur. First of all, there needs to be consumer confidence before those consumers start to loosen their purse strings. On January 27, I wrote an article discussing how comparing the consumer staple index to the consumer cyclical index can help in determining this confidence by consumers. Second, retail spending needs to increase. On January 29, I wrote an article that showed that the retail market sector still had further to go on the downside. And the third thing that needs to happen is that the financial market sector needs to turn upward. The financial market sector typically leads the broader stock market. Therefore, if we can determine that the financial sector has turned upward, we then know that the stock market is not far behind in turning upward as well. Today, I'm looking at the current technical situation of the financial market sector.

Figure 1 shows the daily bar chart of the Financial Select Sector SPDR (XLF). This chart shows that over the last four months, XLF has been in the process of forming a falling wedge trading pattern. Falling wedges are rare and normally occur at or near the end of a trend. As such, this falling wedge is foretelling the end of the current downward trend for the financial market sector. In terms of the Elliott wave theory, these falling wedges are called ending diagonals. The Elliott wave theory suggests that there will be a final leg downward that will penetrate the lower support boundary line of the ending diagonal. By looking at the chart, we can see that XLF is currently testing this lower support boundary line.

FIGURE 1: XLF, DAILY. This chart shows a falling wedge trading pattern that normally occurs at the end of a trend. This chart also show the accumulation/distribution indicator below the price chart.

Graphic provided by: StockCharts.com.

To determine just how low we should expect XLF to fall if it successfully breaks out below the lower support boundary line of the falling wedge formation, note that the symmetrical triangle that has formed within the boundary of the larger falling wedge. Note further that XLF has broken out to the downside of this symmetrical triangle. To measure the extent of the move down from the breakout of a symmetrical triangle, it is normal to project the widest distance of the triangle from the breakout point. I have identified that the widest price difference of the symmetrical triangle with two red arrows. Projecting this price difference from the breakout price of the symmetrical triangle yields a price target of $6.00. This, then, is the expected price target of the complete move downward for XLF.

To further help support the analysis that XLF is on the verge of completing its move downward, I have shown the accumulation/distribution indicator. The accumulation/distribution indicator measures volume. The basic premise behind this volume indicator is that volume precedes price. Many times before price starts to advance, there will be a period in which volume increases just prior to price. Looking at the accumulation/distribution indicator with respect to XLF, as price continues to move lower, the accumulation/distribution indicator has been moving upward by forming higher lows. This indicator is informing us that volume is increasing and we should expect price to follow suit in the not-too-distant future. From a technical analysis viewpoint, this is called a bullish divergence. Bullish divergences are often found at the end of a trend and in themselves forewarn of a pending change in the direction of the trend.

In conclusion, XLF looks to be forming a falling wedge trading pattern that is foretelling the end of the downward trend in the financial market sector. A final leg downward to the price target of $6.00 is expected and will mark the end of the trend. Once the financial sector has bottomed and turned upward, we can then expect the broader stock market to follow suit within the next several months.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.