Financials

With Financial Credit, both Senior and Subordinated in both Europe and the US taking a turn for the worse and considering Financials recent relative performance (which has been high), it's time to take a closer look at what's going on there.

I consider Financials, Energy and Technology the 3 essential Industry groups, so a change in any one of them is important to see coming.

It also should be noted, that the ECB is gearing up for the second LTRO this week (Long Term Repo Operation in which they take bank assets as collateral for a 3 year, 1% loan) which is expected to be much larger then the first. The idea of the LTRO was that banks in the EU who desperately need to shore up their tier 1 capital as required by mandate, would use the 3 year loan to buy sovereign debt which has been in the recent past, yielding 6-7% in some countries. This is known as a carry trade, unfortunately for Sarkozy who trumpeted how successful the LTRO would be at doing that (being the ECB is banned, just like the F_E_D from participating in direct primary debt auctions), almost all of the money went right back in to the ECB's deposit facility which yields .75%, so banks were taking the money, but rather then financing carry trades (although there have been a few, but far from what was envisioned) they were getting it OUT of the financial system and in to the safety of the ECB's deposit facility to..... you probably guessed it as it was predictable, to shore up their tier 1 capital base rather then issuing new shares at depressed prices. The important thing to note (and EU financial institutions have been trumpeting this like a badge if honor, making sure everyone knows they didn't take LTRO cash) is the banks that did take the LTRO cash are being hit 4x harder then the ones that did not. This too was predictable as we saw the same thing happen in the US to banks that borrowed from the F_E_D's discount window. The market assumes that the banks taking the money are the ones in the worst shape and probably accurately. As the ECB has lowered collateral standards below the last LTRO's single A rating, the next take up is expected to be enormous, however with the banks who took the money being punished in the market, it will be interesting to see just how big the take up is vs. consensus. Also what we should be paying attention to is the Deposit facility and how much of the cash goes in to it, Greece has become a real problem for the banks and I suspect they will choose to hold onto the cash rather then finance carry trades as Greece becomes an "unknown, unknown". Furthermore, the Greek PSI deal, if it gets done, could set some very dangerous precedents for bond buyers, especially now that they realize the ECB will not participate in any write down. This means the more debt the ECB holds of any particular sovereign, the bigger the private creditor potential write down will be when Portugal, Spain, Italy, or Ireland seek to get equal and fair treatment and look to have their debt restructured.

It may sound a little complicated, but if you read it once more, I think the gist will be clear. It's a pretty simple market dynamic that as always comes down to the balance between fear and greed and there's no doubt that fear is the stronger of the two drivers of the market; just look at the 2003-2007 bull market, the bulk of the gains and then some were erased in 8 months, after taking 5 years to build them.

On to Financials...

 Today financials are an under-performer as you can see on this 1 min sector rotation chart as compared to yesterday.

 Longer term they have come in and out of rotation a couple of time, but most recently they have been in rotation since December or so.


Starting from the short end and working to the longer timeframes...

 This shows, much like the market update, late day distribution yesterday in financials, much like what we saw last Thursday afternoon before Friday's drop.

 On the close up 2 min chart we see the same negative leading divergence in to afternoon trade and in a flat environment.

 Longer term, it seems there's been distribution since the NFP on Feb. 3rd, I suppose either smart money didn't believe the ridiculous and arbitrary seasonal adjustment or treated it as "sell the news" XLF is now leading negative on the short term going back before the Non-Farm Payrolls.

 The same is seen on the 5 min chart with a head fake at the yellow box, which was also the top for financials.

 The longer term charts have shown a deep and long leading negative divergence on this 15 min chart.

 The same on the 30 min, although this does show an accumulation and mark up cycle before distribution.

And on this hourly chart.

3C usually responds to these divergences within days, (during the early Aug to late September 2011 choppy market, 3C responded so quickly that the MP made 80%)  there have only been a few times when they went on and I only see it in major market once or twice a year, it happened at the end of the G.W. Bush administration after a 5+ year rally in oil that took it from $20 a barrel to over $145 a barrel, that divergence went on for a while and started somewhere around 3 months before Crude topped and then saw an 80% decline in 7 months, bringing crude down to the low $30 area. The same happened with the US dollar in 2008 and 2009, both runs higher made significantly more gains then when the divergence first started, so if you had bought when the divergence first started and sat through the drawdown, you still made huge money (considering the Dollar Index's beta). It's happened with several stocks as well, but in all of these major divergences, they have accompanied major moves that went well beyond where the divergences first started.