Proceed With Caution on the XLF

 | Apr 10, 2013 | 4:00 PM EDT
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Much of the recent rally was led by the financial sector, predominantly names within the Financial Select Sector SPDR (XLF). For a healthy economy, we need a strong and vibrant financial sector.

Let's take a look the companies within the XLF from a valuation and fundamentals standpoint.

XLF Components, Valuation
XLF Components, Fundamentals

With earnings season now underway it is very important to look at where revenue is really coming from. From traditional core lines of business, which varies for every company, or new sources like Morgan Stanley (MS) increasing its wealth management division and decreasing its risky business lines that garnered the majority of profit in the past. We also know that banks have been restructuring divisions and laying employees off to meet the new capital requirements and regulations that come out. So, in terms of net income, it is important to take a look at what is really driving that net income as expenses should be down somewhat as layoffs have been persistent in the first quarter.

Companies in financial services are looking good overall compared to the broad market in terms of valuations and key metrics. They remain cheaper, well capitalized and with strong margins and low debt/equity ratios. But as new regulations kick in and restructuring is completed in financial institutions, it is a good idea to remain patient and cautious about what could come out of the banks. Drilling down in the sources of revenue and cost cutting is where I will be looking at as well as how they are managing risk via trading and headcount.

The Technical Picture

Right now, we see a pullback currently occurring after a wave 5 had completed. It has yet to be confirmed whether it will follow another 5-wave sequence of a longer rally with just a slight pullback in the interim or will be followed by a possible 3-wave corrective sequence depending on how the economic data holds up. Since financials were the leaders it is crucial to wait and see what the Federal Reserve will do. The outlook looks great from the fundamental side of things, but when technicals say something else, remember prices speak first, then the fundamentals chime in.

Financial Sector SPDR (XLF) -- Chart 1
Source: Yahoo! Finance

Taking a look at the point-and-figure charts we see that price is coming along to a resistance point at 18.5. Further monitoring of this chart will see where the bulls and the bears decide to take the price action.

Financial Sector SPDR (XLF) -- Chart 2
Source: Yahoo! Finance

All signs point to the XLF taking a breather, but to what extent is uncertain.

The names that look good fundamentally and technically are Morgan Stanley, JPMorgan (JPM), U.S. Bancorp (USB) and Goldman (GS). Take care with the ETF as a whole and select the best of breed.

Charts to Keep in Mind

Morgan Stanley entering into a wave 5 and the forward cloud is bullish. The smaller wave pattern within the longer, in which wave C has finished, only confirms that all signs point to the upside for MS going forward.

Morgan Stanely (MS)
Source: Yahoo! Finance

Goldman Sachs entering into a Wave 5 on the larger wave and closing out a minor C wave to the downside. Forward cloud confirms with the next wave pattern to the upside.

Goldman Sachs(GS)
Source: Yahoo! Finance

American Express (AXP) is at the end of a wave 5 in both the bigger and smaller waves. This will be an interesting earnings call as it has such a loyal user base and caters to the more affluent client. The chart is a mixed bag as the cloud shows that going forward it still has room to run, but the wave structure is telling a different story in that a pullback is imminent, as it has already started. Overall, this is a good name to be bullish on for the longer term. I am suspecting nothing more than just a minor correction as its long-run story and fundamentals look great.

American Express (AXP)
Source: Yahoo! Finance

U.S. Bankcorp is by far one of the best-run banks in the country as it keeps its business very simple at a regional level. With strong management, very strong profit margins and ROE along with a low P/E compared to the sector and ETF holdings as a whole, this is a great play where both the fundamentals and technicals both agree to the upside for its strong performance.

U.S. Bancorp (USB)
Source: Yahoo! Finance

JPMorgan will be one to watch to see if price action can get above 50 and stay there. But once again, fundamentals and technicals seem to agree. Valuations look good with JPM carrying a P/E of 9.2, while that of the ETF is around 15. It carries a very nice dividend yield of around 3%, which is a fantastic place to park some cash. Lastly, from the charts above they confirm with the fundamentals that the story is bullish as the clouds going forward are bullish and we are entering into wave 5.

JPMorgan Chase (JPM)
Source: Yahoo! Finance

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volatility is quite low here, and we could see some downsides here in the short term. ...



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