How to tell if it's time to invest in banks again

Feb 04, 2009

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After all the talk about being glad to see the back of 2008, this year hasn't exactly presented the change in fortunes that investors had hoped.

On the contrary, in fact. Having initially rallied over the first few trading days of the year, the S&P 500 promptly reversed course and ended up with an 8.5% loss for the month - the worst January on record.

In my last 'Sector Watch' column, published on 19 January, I talked about the importance of the 815-point level on the S&P 500 index. The reason was simple: A couple of closes below that level would probably lead to a test, or break, of the November lows.
The following day, the S&P closed around 805 (the only close below 815), only to then surprisingly rally back up to the 877 area. The buzz was short-lived, however, and the selling quickly resumed.

A critical week: here are the bearish and bullish scenarios

Last Friday, the S&P closed just four points above its lows for the week (821.67). Such a narrow gap makes this week's action critical. Let's break it down…

Bearish Scenario: The November low was around 741 points. If the S&P closes below the January 20 low of 805, it should lead to a test, or break, of that November low.

Bullish Scenario: In order to turn bullish, the S&P would need to close above the 920-point area a couple of times.

Over the long-term, the watchword is 'consolidation'

Clearly, the broader market's short-term pattern remains bearish, with optimistic investing sentiment at a premium at the moment.

Over the longer-term, however, the market may actually be tracing out a large consolidation pattern between the November low of 741 points and the January high of 943 points. I've illustrated this on the chart below…

The reason I see a potential longer-term consolidation pattern here is that when a market (or stock, for that matter) moves dramatically in one direction, it then needs time to 'reset' (i.e. sort things out).

And for the S&P 500, 'dramatic moves' have become as common as having a hot dinner. From the high in October 2007 to the low in November 2008, the index plunged by more than 50%.

That 13-month sell-off means that I wouldn't be surprised to see a consolidation pattern last for three to four months… perhaps even longer. And this week's sector holds the key…

This leading sector could project the market's future performance again

Keep a close eye on the financial sector (and these days, who isn't?) It's usually a leading indicator for the markets and having already traded below its November lows, it could mean that the stock indexes will follow suit.

However, this time could be different…

The key equaliser in this current mess is that we haven't witnessed a financial crisis like this one in decades. What started in the US has now quickly spread around the world (the downside of 'globalisation').

With world governments and central banks tossing billions of dollars into the global financial system in a desperate bid to shore up economies (and they're probably not done yet), the jury is still out on when the markets will stabilise.

So rather than guess, let's allow the charts to guide us from here…

How you'll know when it's time to turn bullish on the banks

Take a look at the chart below, which shows the KBW Banking Index (^BKX)

No surprise to see the index in freefall since September. And since its 2007 high, BKX is down 76%.

The last shorter-term sell signal from December projected a minimum downside target of $26.40 - a level reached on January 20. This means it's possible that BKX could generate new buy signals from this area.

Given that last September was the last time BKX set a swing high, I've drawn a regression channel from that level. As you can see, the top of the channel coincides with the 50-day moving average, currently around the $40 area.

As time goes by, the channel and the 50-day moving average will move lower, with KBX eventually breaking above the channel. When that occurs, it will be time for longer-term investors to turn bullish.

• This article was written by Jim Stanton for the Smart Profits Report

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