Banks Are Better but Still Dangerous

Financial stocks had an incredible Thanksgiving week, with banks, broker-dealers and insurance carriers lifting more than 30% in response to the government's Citigroup (C - commentary - Cramer's Take) bailout. The powerful rally has raised new hopes that banks are finally on the recovery trail after a horrendous and historic bear market.

A major problem with the ferocious bounce lies in its perfect symmetry with the holiday-shortened trading week. Notably, most financial stocks posted declining volume in each of the four sessions. This drying-up of participation signals a bearish divergence, or at least a non-confirmation that demands our skepticism until we get evidence to the contrary.

KBW Banking Index (BKX)

Click here for larger image.

Source: eSignal

The KBW Banking Index (BKX) illustrates the downsloping volume bars you'll find on the majority of financial charts during the holiday-week rally. However, despite the limp numbers, price action does show a positive influence on accumulation-distribution, lifting on-balance volume (OBV) to its highest level since Nov 4.

This positive sign indicates that real buyers were active during the rally, rather than just typical short-covering activity. Taking things one step further, it's likely that these aggressive investors now believe that financial sector risk/reward profile has shifted back into balance. This should encourage more-skittish market players to enter positions in coming weeks.

But that's where the good news ends, at least for now, because the pattern shows a major challenge that's likely to come into play quickly in this December tape. In this regard, note the inverse cup-and-handle posted between July and November. This bearish formation broke to the downside on heavy volume two weeks ago.

The index has now bounced back to broken support on declining volume, issuing a notable signal for short-sellers to re-enter aggressive positions. This bearish dynamic is likely to trigger a reversal that tests the deep low posted on Nov. 21. It could be a painful event, given the five-day, 14-point rally spike.

Rising accumulation should help on the next downturn and draw in buying interest well above the low. With this in mind, I don't think banks will enter a new bear-market decline for the rest of 2008 and into the first quarter of 2009. More likely, the group will move into a trading range that keeps both sides off balance through January earnings.

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At the time of publication, Farley was long Citigroup, although holdings can change at any time.

Farley is also the author of The Daily Swing Trade, a premium product that outlines his charts and analysis. Farley has also been featured in Barron's, SmartMoney, Tech Week, Active Trader, MoneyCentral, Technical Investor, Bridge Trader and Online Investor. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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