From the desk of Steve Strazza @Sstrazza
Plenty of stocks continue to show relative strength through the recent volatility. We still want to be buying these leaders.
And plenty of stocks continue to underperform, having already violated their year-to-date ranges to the downside. Those are the names we want to be looking at to short.
But most stocks are simply in “no-man’s land” right now.
Some were rejected at their year-to-date highs. Others broke out and quickly failed. It doesn’t matter how they got there. What matters is they’re now “back in the box” and facing the very same overhead supply levels they’ve faced for much of 2021.
It looked as if markets were making progress earlier this month. But it turns out most of these new highs were — dare I say —transitory?
Let’s take a look at financials, using the group as a case study for how we want to approach all the range-bound patterns we see out there.
We’ll start with a recent Mystery Chart. This is a custom index of the six largest banks in the United States:
Momentum is waning, and price is consolidating beneath our objective. This is a logical place to take profits and wait for the dust to settle.
The primary trend is higher, so it’s likely that banks eventually absorb the overhead supply at this level and resolve to the upside. But for now, these stocks are stuck in a range and the bias is sideways.
Patience pays with these types of formations.
Notice the relative weakness when we compare these banks with the large-cap financial sector SPDR $XLF. The big banks never made a decisive breakout at all. Instead, they made a slight new high and rolled over at our objective:
Yesterday, XLF finally followed the major banks to the downside, as sellers drove prices back below their August highs.
It turns out the Big 6 Bank Index was a pretty good warning sign of things to come for financials. It also turns out that financials, in general, were a good warning sign of things to come for the broader market.
The big banks and financials actually peaked back in October and were already rolling over when small- and mid-caps were breaking out to fresh highs last month.
Here’s a closer look at the recent upside resolution and ensuing failed breakout for financials:
Just like the Big 6 Bank Index, XLF is now back in its old range. Price is backing and filling under our objective at the 161.8% Fibonacci extension. As long as we remain trapped here, our outlook for financials is neutral.
The range-bound action taking place in financials right now is best illustrated by the banks. Here’s a look at the large money-center banking ETF $KBE and the regional banking ETF $KRE:
Both indexes reclaimed their first-half highs in October and had been consolidating just above this former resistance level. With the recent volatility, sellers have regained control of this critical level and we’re now right back to where we started… with a mess.
Yields have also backed up recently, and Treasury spreads have tightened. These developments are headwinds for the banks, as their lending businesses are more profitable when rates are rising and the curve is steepening. You can read more about this in today’s Bond Report.
Trendless. Range-bound. Sideways.
This is the current state of affairs for the vast majority of stocks right now. In fact, when we look at small- and mid-caps, it’s the same story:
They’re still stuck in those good old year-to-date ranges that have persisted for most of 2021.
These are consolidations, so, by definition, there’s little directional bias. We can be short against these former highs if we want. But the risk/reward is not great, as we’re merely trading a range.
There’s also a heightened possibility of getting whipsawed and shaken out when trading sideways patterns. In our view, the best thing to do with SMIDs here is collect premium and bet on more chop.
Indeed, this is the case for most stocks right now.
We’d rather be shorting stocks that already resolved lower from their ranges, just like we’d rather be buying those that already resolved higher.
Financials, banks, and SMIDs have done neither. They’re still stuck in the middle.
If and when banks and financials make a valid upside resolution, they’ll move into the “stocks we want to be buying” basket as opposed to the “opportunity cost” basket.
And if and when that happens, we’re likely to see a lot of other areas also reclaim their former highs and break out. This would be a bullish development for the broader market.
As it stands right now, a laundry list of indexes in the U.S. and abroad have just failed to hold their new highs. As long as all these areas remain trapped beneath overhead supply, we’re likely in an environment that’s messy for longer.
The good news is it’s a great time to go fishing.
As always, we love to hear from you, so shoot us a note and let us know what you’re thinking about this market.