A breakdown in Financials = Rising financial stress
Of greater concern is the performance of the PHLX Bank Index (BKX) against the market. The chart below plots the relative performance of the BKX to the market going all the back to 1993. Right now, the banks are now testing a critical relative support level. Instances in the past where it has broken these support levels have been signals of rising systemic risk in the financial system that ultimately culminated in market meltdowns. The first instance warned of the Russia Crisis, which brought down Long Term Capital Management. The second occurred in April 2007, which was the subprime crisis - whose ultimate conclusion was the Great Recession of 2008.
The bull case
While I just trade the signals and don't try to anticipate signals, the prognosis is mixed and I am on the fence on whether it is likely to break down. The banks have not shown me that they have definitively broken relative support - which would be a warning of severe distress. They are just testing support levels.
There is a bullish case to be made. Scott Grannis points out that systemic risks are low right now, largely because of the message from the bond market. I have learned over the years that given a choice between believing the message from the bond market and the stock market, I would tilt towards the bond market.
The bear case
On the other hand, a glance at the relative performance of the Financial Sector SPDR (XLF) for the past two-and-a-half years shows that the Financials may have already broken down on a relative basis. The sector is definitely in a relative downtrend. XLF may have already violated relative support, though arguably it is still in the process of testing a relative support zone.
A place to hide
Nevertheless, I remain conflicted. Certainly there are risks, but the presence of risk doesn't mean that the world is certain to blow up.
During these periods of analytical uncertainty, I believe that a disciplined model such as the Inflation Deflation Timer Model, coupled with secondary indicators such as the BKX or XLF vs. the market, are a good place to hide. If the Timer Model were to signal a period of heightened financial stress, then the model portfolio would rotate into the safety of the US Treasury long bond (unless the crisis is a US default, in which case I would find something else, e.g. Canadas). On the other hand, if things turn around because of a policy response, e.g. QE3, then the Timer Model would move into the aggressive, high beta trade of emerging markets and commodity producers.