The Next Shoe to Drop

In mid March indices began to pull themselves out of the depths of a short-term bottom, what led the way? It was, in part, the perception that financials had passed the worst on bond insurers, large writedowns etc. I remember one of the headlines at the time:

"The positive news is that, in our opinion, the global financial sector appears to have already disclosed the majority of valuation write-downs of subprime?" S&P Credit Analyst Scott Burgie 3/14/08

As recent as this morning or even last week we are still learning about more subprime associated losses. Thursday afternoon the worlds largest insurer, AIG (AIG) reported an unexpected $8 billion loss not long after UBS (UBS) and Merrill Lynch (MER) reported $10.9 and $6.6 billion, respectively. All the while the financial sector continued to climb. The XLF chart below shows this years performance with the dates of each aforementioned earnings announcement. It seems the fundamentals are starting to take the expected toll on the financial sector, which are leading to supportive technical signals that are hard to ignore.

As early as Wednesday this week we received preliminary signals to short financial services, insurance, and regional bank firms. The downward momentum has switched in favor of the bears. There are a few momentum indicators that can be used for individual stocks, but I've found when following sectors a simple MACD signal can be more predictive than other indicators. (Continued Below)

There are a number of financial related ETFs on the market these days; there are insurance, regional bank, and brokerage ETFs. IYF, IYG, and KRE are a few that have started the reversal and are gaining bearish momentum. While this occurrence has happened one other time since the larger market reversal, this may be the first time bearish signals are being supported with fundamental news, not to mention a broader market over-extension. I've plotted the three ETFs below, the chart shows each time the MACD sell signals have occurred and the following losses, as expected the KRE, the regional bank index, suffers the worst (blue line), this pattern is not expected to change in the next downturn.

On the other side, the Dow Jones Financial Services ETF (IYF: green) may be the most overextended. Its gain has outpaced regional banks and insurance in the last month, which may show it has more to fall.

Friday's opening bell just sounded a few minutes ago and every DOW component is down, this move is led primarily by the surprise AIG announcement that its in need of cash. After seeing bearish signals from financial services, insurance and regional bank indices; the AIG news may very well be the ignition to the next hard fall. Not unlike last August, or the recent February panic, the next downturn may be led by the financial sector.

Andrew Hart
Research Analyst