June 7th, 2009

XLF (Financial Sector ETF) = Market Health

You might expect that watching the market from the sideline this past week (as you know, I’ve been out of town) should have brought the future into clearer focus. Unfortunately, it’s still as murky as it was when I left on Monday with a change of just 2.78 points on the S&P 500 Index. Because the Index didn’t do much, neither did many stocks.

Much has been made of the markets having crossed above the 200-day moving average, it is still struggling to break with conviction above the neckline of the inverse head-and-shoulder forming since October. In fact, the Index is almost exactly where it was on October 29, nine long months ago (930.09 vs. closing last Friday at 940.09).

The 60-day moving average is following closely behind the Index as it moves up. I now see less risk in the Index regressing and falling back below the 180-day than in its falling below the quickly rising 60-day. Over the past 60 years of data I’ve accumulated, the 60-crossing above the 180-day is less compelling than the Index reversing and declining again below the 60-day, a decline of that magnitude risks negating all the progress made since March 9. Here’s the situation I’m describing:

However, the most disconcerting is the negative convergence between volume and the Index. While the Index has continued to advance, On-Balance-Volume has trended lower. In other words, the volume on up days have been less than the volume on down days, never a good sign.

I remember last year how all the “talking heads” saying that the key to the market’s turn around was recovery of the housing market. The focus was on the surge in foreclosures, the absence of mortgage financing and weaking of consumers’ sense of wealth from declining house prices. Some say that corner has been turned.

I think the key to solidifying the market’s turn, to a true change in momentum from bear to bull is financial stocks starting to move up. I wrote about it at length on May 19 and am becoming even more convinced now that, from this point forward, financials will lead the market. Here’s an update of the XLF:

Note the similarity between the S&P 500 Index and the XLF Financial Sector ETF. The financial sector is tied up with economic health, exchange value of the $US, interest rates and the health of the financial system itself. I’ll rest easier when I see the XLF successfully and with conviction cross above it’s neckline.

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