Financials Rally

One of the more dangerous things an investor can do is try to pick a bottom. Picking the top is no easier. The sad fact is that markets always go down more than we think they can, and also go up more than we think they can. Legions of technical analysts have tried to develop indicators that identify tops and bottoms. Some of these indicators work, sometimes, but none are foolproof.

We say this because the question now before us is important: did the sharp intraday decline on Wednesday of this week market an important bottom? The benchmarks broke below the prior lows in November and then reversed near the lows set in March 2007. This morning there seemed to be little follow-through at first, then two important news items hit the wire. First, Fed chairman Ben Bernanke delivered a speech in which he all but promised additional aggressive interest rate cuts. Second, a rumor emerged that Bank of America (BAC) is in talks to acquire troubled mortgage lender Countrywide Financial (CFC). Within seconds, CFC stock had jumped 70%. A buying frenzy quickly spread through the financial sector. The economically-defensive sectors like health care and utilities suddenly lost their allure as buyers piled into financials.

Our first inclination is to suspect that a lot of today's gain was really short-covering by hedge funds that had placed bearish bets on financials. If the strength in financials persists for a few more days, we will know that something more is happening. For now, it appears that the benchmarks are heading toward a retest of their downtrend. Next week we will start to see 4Q earning reports. Positive surprises could create some further upside momentum. Negative surprises will do the opposite.