BANKS DRAW A LINE IN THE SAND / BARRON´S MAGAZINE

Getting Technical

Banks Draw a Line in the Sand

By Michael Kahn 

 

Old bank sign engraved in stone or concrete above the door of financial building concept for finance and business Photo: Getty Images

 

Normally, a technical breakout in the bank sector would herald a new leg up for the broader market.

With financial companies representing about 16% of the weight of the Standard & Poor’s 500 index, second only to technology, the math says the path of least resistance should be to the upside.

Considering that banks lagged the market for most of the past year, the fact that they seem to be taking the mantle of leadership as big tech stocks pull back should be a great development for the bulls.
 
The market doesn’t mind if its leaders stumble as long as another group steps up to lead. That’s one reason why the S&P 500 was able to not only rally to new highs but accelerate its pace.

This, even as big tech—as represented by the Technology Select Sector SPDR exchange-traded fund (ticker: XLK)—fell 3% over the past week
 
In contrast, the SPDR S&P Bank ETF (KBE) rallied as much as 5.6% before pulling back a bit (see chart).

Market skeptics might say that the sudden awakening in the bank sector isn’t the result of money seeking better potential returns. Instead, it’s a defensive move, with money fleeing the hot tech sector to a safer place where the rally is not nearly as extended. If so, it may not result in another leg up for the market—but it does mean investors’ portfolios will have less room to fall.

In Monday’s column, I warned that the rally had kicked into dangerous overdrive, meaning that something had to give soon. In that light, the banks have a big responsibility to hold their ground right here and right now. If they don’t and the sector breakout fails, it will give the bears all they need to get very aggressive.

 

But why should that be? We can argue over the content of the proposed tax-reform bills as they work their way through the reconciliation process, but that’s not it.

Technically, the SPDR S&P Bank ETF has a nice upside breakout, and over the past two days a pause allowed it to digest that important event. To remain a viable bullish signal, the ETF must hold its breakout and establish a new higher trading range at a minimum. Even better would be upside follow-through.

Failure for banks to stay strong while tech remains in a corrective dip—and as the No. 3 sector, health care, is showing a rather violent downside reversal—would put the overall market in serious, albeit short-term, jeopardy. Even with these developments, I am not convinced that the long-term bull market is over just yet.

There is one more consideration making the bank breakout a bit shaky. The yield curve is now as narrow as it was in late 2007. In other words, the spread between long- and short-term Treasury interest rates seems to be heading in the wrong direction for an economy that puts out good news on a regular basis.

To be sure, the curve is narrow, but not yet narrow enough to trigger a recession. A flat or even inverted—that is, negative—curve would be that signal.

The problem for banks is that a big part of their business revolves around borrowing money at short-term rates and lending it back out at long-term rates. The steeper the yield curve, the better their profitability, so a curve this narrow could be problematic.

After the election last year, the yield curve rallied—that is, got steeper—and banks rallied sharply as well. Both started to fall together at the start of this year. Right now, the curve is weak, while banks are strong. One of them is likely to change direction, and it seems that banks should follow the curve, not the other way around.

If banks do resist the yield curve, then I give them credit for their internal strength and look for any market correction to be mild. However, if they cannot hold their breakout, then I would like to hold a little more cash to ride out the inevitable correction.


Michael Kahn, a longtime columnist for Barrons.com, comments on technical analysis at www.twitter.com/mnkahn. A former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, Kahn has written three books about technical analysis.