Financials Are Breaking Key Support On a Relative Basis

One of the worst sectors in the US Stock market over the past year has been Financials. A space where we want to see leadership in a bull market has actually been quite the laggard. This might be a problem for the overall structure of the stock market, but today we're just going to focus on this space in particular. I've been watching this chart looking for a breakdown for most of the summer. But I think the break is happening now.

Here is the same daily line chart that we've been focusing on since June. Look how many times this support has been tested and just now hitting fresh 20-month lows potentially (and likely) taking out all of the support since the beginning of 2013:

This key support comes right near the 38.2% Fibonacci retracement from the rally off the lows in the summer of 2012. This looks to me like a big round topping pattern likely to cause quite a sell-off upon confirmation. We really only want to be short this spread below that support. Big topping patterns like this often come along with whipsaws. And although we've actually experienced a couple of failed moves in the last few months, my experience tells me that this level is really vulnerable to a violent collapse.

From a trend perspective, as technicians we would much rather to be on the side of the underlying trend, especially after a nice long consolidation like this. We've obviously been trending lower for over a year and the smoothing mechanisms agree. Here is the same chart but this time with the 50 and 200 day moving averages overlaid so you can see the downward sloping smoothing mechanisms putting added downside pressure on this market:

I find it hard to believe that we're going to get a vicious rally higher with this much downside pressure. I'm definitely leaning extremely bearish this market, but remember specifically on a relative basis. In this case, we are talking about a short position in Financials (XLF) while long an equivalent dollar amount of the S&P500 (SPY) to neutralize the position and profit specifically from further relative weakness in the financial sector.

From a risk management perspective, two closes above 11.62 on this spread would force me to reevaluate this theses over the short-term. I don't think this would change this chart structurally, but the risk/reward would no longer be as favorable as it currently stands. I'm more than willing to change my mind if the changes in data force me to do so. Right now I think this is the lower probability scenario, but something we worry about and prepare for regardless. Remember the market doesn't care what I think and is going to do whatever it wants.

In this case I think financials keep getting crushed relative to S&Ps. We'll see....

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Tags: $XLF $SPY