What I'm Keying On to Determine if the January Rally Will Fail

In my stock market “atlas” piece from two weeks ago, I said the S&P 500 rally “could last for a little while longer and extend a bit further.” I also shared an upside target in the “mid-2,600s.” The S&P hit it shortly thereafter and has subsequently stalled out.

Now the question is whether my NEXT forecast will pan out: A pullback in stocks that leads to a retest/near-retest of the December lows. I’m keying on one market sector to see if that call is on target: financials.

If you’ve been following my work over the years, you know I was extremely bullish on banks, brokers, insurers and other financial stocks in the wake of the Trump election. I pointed out how small caps and financials were leading the market in this piece around Trump’s inauguration, for instance. Then in February 2017, I wrote that a “perfect, positive storm for financial stocks in general, and bank stocks in particular” was likely to send the entire sector higher.

The Financial Select Sector SPDR Fund (XLF, Rated “C+”) — and many individual bank stocks — rallied nicely in the wake of those calls. Most hit fresh highs at the beginning of last year.

But with the yield curve flattening relentlessly, market volatility beginning to rise, and credit markets starting to tremble, financials started to lag soon thereafter. I sensed a major turn was coming, and alerted you in April 2018 that it was time to get out of these stocks.

What happened? The XLF failed to make a new high with the S&P 500 in September. Then it collapsed in October and again in December. In fact, the benchmark ETF briefly plunged to its lowest level since November 2016.

Some recent re-steepening of the yield curve helped the sector bounce in January. So, did decent earnings news from the major U.S. “money center” banks like JPMorgan Chase (JPM, Rated “B”) and Bank of America (BAC, Rated “B-”).

But even the 10% XLF rally over the past month just put the ETF back to where it traded in early December. And as I’ve mentioned frequently, sharp, short-term rallies like that are much more common in BEAR markets than BULL markets.

Moreover, mainstream media outlets are now warning aggressively about many of the same excesses and future financial problems I warned you about over the past 12-18 months.

The Wall Street Journal just covered the outrageous investing behavior and valuation extremes in the tech sector, for instance. The article went on to suggest that bubble is starting to pop because easy money is drying up. Or as one venture capitalist put it, investors are “swapping ‘fear of missing out’ for ‘shame of being suckered.’”

Meanwhile, the Financial Times recently unveiled a series of articles called “The Debt Machine.” They focus on the surge in incredibly reckless corporate lending, and how major losses are likely coming down the pike for investors in debt-laden companies.

That mirrors the argument I’ve been making, namely that what happened this time around in the CORPORATE market was every bit as ridiculous and dangerous as what happened in the MORTGAGE market last time around.

Bottom line: We’ve seen the financials rolling over for the better part of a year, and we’ve seen a sharp, short-term bounce.

Risk spreads are widening. Borrowing is getting more expensive. And a major turn in the credit cycle is underway, with delinquencies and defaults beginning to head higher after a multi-year stretch of declines.

So, I’ll be watching closely to see how these key stocks behave in the coming weeks. If I’m right, and the credit environment is only BEGINNING to change, they should soon run out of gas — and lead the market lower again.

Until next time,
Mike Larson