May 18th, 2009

XLF (Financial Sector ETF): What Now?

“I know nobody knows the future.. but what is the chance for XLF going back to $8.67? Thought the fix is in for finance, XLF is the only one sector that can cause SPX to go lower from here.”

That was a comment I received last night but, because Financials are something that nearly everyone is interested, thought I’d think this through with you, right here.

Others may talk about the Federal bailout the banks received, the new stock secondaries many banks are making to shore up their capitalization, the nearly infinite profit margins banks can earn due to the unprecedented spread between their cost of funds and their lending rates. That’s too much for me to process and, if I could, I wouldn’t know how to evaluate the impact of all those factors (and many more I hadn’t listed) on each individual bank and, finally, figuring out whether current stock prices already factored in all these forces and where some undervalued opportunities might still be found.

And then collapse all these statistics into one Index. According ProShares, its sponsor and creator, the XLF Financial Sector etf as of March 31 consisted of:

Banks 35.74%
General Financial 30.12%
Nonlife Insurance 17.56%
Real Estate Investment Trusts 11.67%
Life Insurance 4.41%
Real Estate Investment & Services 0.49%

Its 10 largest holdings consisted of:

JPMorgan Chase & Co.
Wells Fargo & Co.
Goldman Sachs Group Inc.
Bank of America Corp.
Bank of New York Mellon Corp.
U.S. Bancorp
VISA Inc.-Class A
Travelers Cos. Inc.
Morgan Stanley
CME Group Inc.-Class A

We assume that smarter people than us (at least those who are the big money players) are continually doing the homework, completing the computations and evaluating whether the underlying stocks are properly valued or not and, finally, whether the XLF price accurately reflects the underlying securities.

As chartists, all we can effectively do is monitor their actions as reflected in the securities price and quickly move to piggyback on their analysis and free-ride on their decisions. So what does the chart look like:

On the surface, XLF seems to be making what looks like the beginning of an inverse head-and-shoulder, a stock pattern that looks similar to the S&P 500 Index pattern (see the chart in yesterday’s post). I’ve extrapolated into the future and projected the four possible outcomes:

  • A: XLF successfully crosses it’s 180-day MA, crosses the neckline of the inverse head-and-shoulder and proceeds up to the next potential resistance at 17 (a level that served as pivot points last October, September and August).
  • B: Along with the market, XLF continues to retrace to around 9.50 where the moving averages serve as a resistance and a bouncing off point. By then the 60-day would have crossed the 90-day MA and the 180-day would be close and an easy cross over.
  • C: The moving averages fail as support and XLF attempts to catch some resistance above its all-time low at 5.88 (intra-day).
  • D: Currently unforeseen and unanticipated new events come to the surface sabotaging the Government’s remediation efforts to date and XLF undercuts the previous low.

Simply put, I still see it in the short run as a 50/50 proposition. There’s only a one-in-four possibility that XLF will be able to cross the resistance at the 13.00 neckline allowing it to move up to 17.00. It’s almost certain that 12-18 months from now XLF will be double what it is today, we just can’t say when. There’s a three-in-four chance that XLF could go lower before it crosses the neckline.

That’s why I like to wait for a breakout rather than hoping to jump in early in anticipation. This is true for XLF, for any stock and for the market in general as it struggles to cross the 180-day moving average and completing what appears to be an inverse head-and-shoulder in the SPX. We can take smaller positions and watch (be 50% invested/50% in cash) but at the first sign of weakness, of the pattern beginning to fail, to admit a mistake, sell and conserve my capital for another try later.

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