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. Chart Advisor

    These Oil & Gas Stocks Have Reversed

    It's been a long downtrend for oil stock owners, but there's hope. These four oil and gas stocks have reversed and may keep trending to the upside.
  2. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  3. Professionals

    5 Top-Rated Funds for Your Retirement Portfolio

    Mutual funds are a good choice for emotional investors. Here are five popular funds to consider.
  4. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  5. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  6. Investing News

    These 3 High-Quality Stocks Are Dividend Royalty

    Here are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
  7. Stock Analysis

    An Auto Stock Alternative to Ford and GM

    If you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
  8. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  9. Chart Advisor

    Bumpy Roads Ahead In Transportation

    Investors are keeping an eye on the transportation industry. We'll take a look at the trend direction and how to trade it.
  10. Investing

    How ETFs May Save You Thousands

    Being vigilant about the amount you pay and what you get for is important, but adding ETFs into the investment mix fits well with a value-seeking nature.
  1. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  2. Can mutual funds invest in IPOs?

    Mutual funds can invest in initial public offerings (IPOS). However, most mutual funds have bylaws that prevent them from ... Read Full Answer >>
  3. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  4. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  5. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  6. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!