The recent rally in the financial sector raises the issue of whether it's time to reestablish short positions in the group in order to take advantage of an extremely overbought situation and the inevitable profit taking that is sure to come.
The S&P 500 financial sector is now trading 28.5% above its 50-day moving average, which is the highest level recorded since 1990. This is reflected in the performance of the Financial Select Sector SPDR (NYSE:XLF), which is up 90% from its 52-week low.

IN PICTURES: Eight Ways To Survive A Market Downturn

While it wouldn't be against the laws of physics for the sector to go higher, it's probably safe to predict an upcoming pullback. It would be logical to short the banks that have moved up the most due to short covering and a change in sentiment, rather than in response to fundamentals.

Big American Recoveries
Regions Financial (NYSE:RF) has nearly doubled off the low it reached in March 2009. This recovery was led by the bank's surprise announcement that it would report a profit in the first quarter. Investors should probably be wary about the quality of this report, as both Goldman Sachs (NYSE:GS) and Citigroup (NYSE:C) boosted earnings through accounting maneuvers rather than core profits. Goldman Sachs changed its fiscal year, which had the incidental effect of excluding the month of December from its earnings, while Citigroup booked a $2.5 billion gain from marking down its liabilities.

Real Estate Fears
Fifth Third Bancorp (Nasdaq:FITB) also had a huge move, more than tripling off the bottom recorded in March 2009. Yet Moody's just downgraded the company to Baa1, and Fifth Third has exposure to weak real estate markets in Michigan and Florida. During the bank's fourth-quarter conference call, it said that "37% of our commercial real estate non performing assets" were from these two areas.

Surging British Banks
The British banks may also be a place to lay down some short bets. At the beginning of the year, investors had written off the banking system here as all but insolvent, but now both Lloyds Banking Group plc (NYSE:LYG) and Barclays plc (NYSE:BCS) have surged off their lows.

The British government now has majority control of Lloyds and the bank participates in an asset protection plan sponsored by the government. Although this may have strengthened the bank in the eyes of the market, one could argue that with the government firmly in control, and the experience of the American government meddling in our banking system via the Trouble Asset Relief Plan (TARP), there's no telling what the British government will do next.

Barclays is in better shape and declined to participate in the asset protection plan, and is instead selling assets to boost capital. The bank may suffer, however, if a downward trend reasserts itself in the financial sector.

The Bottom Line
The recent overall market rally, and financials in particular, has reinvigorated the dwindling community of bulls on Wall Street. However, this sector has moved ahead of fundamentals, and may be headed for a pullback. Evidence of this can be seen from Bank of America (NYSE:BAC), which reported in its latest earnings report that "credit quality deteriorated further across all lines of business as housing prices continued to fall and the economic environment weakened." The bank now has a provision for credit losses of $13.4 billion. The bottom line is that investors who play the short side may want to reestablish positions in financials prior to the expected profit taking. (For more, see Finding Short Candidates With Technical Analysis.)

Related Articles
  1. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  2. Chart Advisor

    ChartAdvisor for November 27 2015

    Weekly technical summary of the major U.S. indexes.
  3. Chart Advisor

    Pay Attention To These Stock Patterns Playing Out

    The stocks are all moving different types of patterns. A breakout could signal a major price move in the trending direction, or it could reverse the trend.
  4. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  5. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  6. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  7. Technical Indicators

    Using Pivot Points For Predictions

    Learn one of the most common methods of finding support and resistance levels.
  8. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  9. Mutual Funds & ETFs

    Buying Vanguard Mutual Funds Vs. ETFs

    Learn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
  10. Mutual Funds & ETFs

    ETFs Vs. Mutual Funds: Choosing For Your Retirement

    Learn about the difference between using mutual funds versus ETFs for retirement, including which investment strategies and goals are best served by each.
  1. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  2. Do ETFs pay capital gains?

    Exchange-traded funds (ETFs) can generate capital gains that are transferred to shareholders, typically once a year, triggering ... Read Full Answer >>
  3. How do real estate hedge funds work?

    A hedge fund is a type of investment vehicle and business structure that aggregates capital from multiple investors and invests ... Read Full Answer >>
  4. Are Vanguard ETFs commission-free?

    While some Vanguard exchange-traded funds (ETFs) are available commission-free from third-party brokers, a large portion ... Read Full Answer >>
  5. Do Vanguard ETFs require a minimum investment?

    Vanguard completely waives any U.S. dollar minimum amounts to buy its exchange-traded funds (ETFs), and the minimum ETF investment ... Read Full Answer >>
  6. Can mutual fund expense ratios be negative?

    Mutual fund expense ratios cannot be negative. An expense ratio is the sum total of all fees charged by an asset management ... Read Full Answer >>

You May Also Like

Trading Center