Importance of the Financials

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Importance of the Financials

Introduction

This article will elaborate once again on the crucial importance of the Financials. In order to lay down my case, I will break the article into three segments and each will build on the previous one. Every one of these segments is going to address something that may not be transparent to the eye of the beholder. A clear pattern will emerge at the end.

For simplicity's sake, I call the first part Fundamentals when in fact I am examining sector allocation in the four major indices, actually their respective Exchange Traded Funds. The second is named Technicals, and the last one is the Option Chain Interpretation.

PART 1: Fundamentals (Sector Allocation)

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Let me start this section by asking a crucial question: "Is the US stock market overexposed to the Financials?!?" The answer is given in Figure 1. The figure below shows the sector weightings of the four major ETFs. I have purposely placed them in the order of exposure to point out that the Small Caps (IWM) are the most exposed to the fate of the Banks. Small businesses are virtually at the mercy of the Banks. Currently Bank of America (in California's Orange County) is not lending anything less than $25,000 except under the condition that the annual company earnings/sales are at least $250,000. These rigid standards disqualify a lot of small Mom & Pop businesses. At JPM Chase (previously WaMu) locations, also in California, only one out of 10 small business loans get funded. What is this telling us? Shortage of credit, unwillingness to lend, or fear?



The one point to keep in mind is that there is overexposure to the financials in the US markets. Could the weighting be changed? Sure it can; back in 2005, SPY exposure to the financials was as high as 25%, yet in early 2009, out of fear of going lower, it was reduced to single digits, around 9%.

As it can be clearly seen from the figure above, QQQQ does not have any exposure to the banks. Also, I gave credit to the source from where the information was obtained at the time of writing this article. The greatest competitor of Yahoo is GOOG and I also visited their financial page. A snapshot from the Google finance page is on Figure 2.



Figure 2 was a snapshot at the close of the day Tuesday, 09-07-2010. It shows the various US sectors; XLF (financials), XLE (energy), XLV (health care), XLI (industrial), XLY (consumer discretionary), XLU (utilities), XLK (technology), XLB (basic materials) as well as KRE (regional banks). The reason why I want to bring SPDR Regional Banking into the discussion will become evident in PART 3. For now, let us turn our attention to Figure 3, which shows the regional banks which are in the KRE.



These top 10 Holdings represent 25.84% of the total asset allocation of the KRE. Obviously JPM, BAC, and GS are not included in it. Next, let us move to the technicals.

PART 2: Technicals (Channeling Financials)



These charts aren't daily but weekly. The grey lines show clearly that each of the underlying is currently trading sideways and that is all that needs to be said from the technical view point.

PART 3: Interpreting the Option Chain

What I want to show here is visually displayed on Figure 5.



The KRE option chain for September, with 10 days left to expiry, has an imbalance in the volume of traded calls versus traded puts (blue rectangles). Observe that Open Interest (red rectangles) for the puts has more significant numbers, while on the call side, numbers are small. Do I need to repeat that the same was the scenario back in November of 2008 prior to Election Day? I also checked the Open Interest and volume on the individual strike prices for SPY for December 2008. It loudly brought to my attention how obvious it was that there were more puts traded than calls. Looking at the numbers of Open Interest and the volume from these two time frames spoke to me a multitude of things. For instance, it really did not even matter to Wall Street who took office for it had already been decided that the market was heading south.

To bring it to the present, I do not wish to make a clear cut comment here, but somewhat more of a softer one. It might be extra difficult for the US financial markets to go higher when there is so much weakness "under the hood." If the market is going to go higher, then the strongest stocks of the strongest sector should lead us higher. Yet, as long as this sideways sector with sideways moving stocks represent the biggest allocation of the US stock market, "we ain't going nowhere" but sideways.

Conclusion

In conclusion, this article has argued the use of fundamental data, such as the sector allocation of each of the major ETFs, as well as the use of technicals, and lastly reading/interpreting the option chain. The observation has led us to the speculation that unless the weighting of the sectors drastically reduces the US markets exposure to the financials, it might be impossible for them to lift higher in the upcoming months before the end of the year. Monitor the financials closely and have good trading.
- Josip Causic


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