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Financials are facing downsides

A weekly examination of the thinking behind a specific trade in the stock, bond or currency markets.

In the wake of CIBC's $2.4-billion (U.S.) lawsuit settlement bombshell, it's not too difficult to find people unloading shares in the financial sector. However, the analysts behind this week's trade don't advise selling financials because everyone else is doing it, but because insiders have been selling.

In a report to clients this week, BCA Research analysts recommended a long position in tech, while shorting the financials. The thinking behind the recommendation is that financial sector insiders have been selling on recent strength, whereas tech insiders have not, indicating tech share prices may still be upward bound.

A composite of the insider sell/buy ratios for the two sectors warns of a drop in financial sector performance relative to that of the tech sector, BCA analysts said. The only time there was a break in the pattern was in early 2001, when the tech bubble burst.

The economic environment in the United States also gives BCA analysts reason to remain negative on financials. "We remain bearish on the outlook for financial shares based on our expectation that: the yield curve will invert, and fears of a downturn in credit quality will escalate as consumption, job and housing growth slow," the analysts said.

The U.S. Federal Reserve Board is on course to keep lifting interest rates until the yield curve inverts, they said. This will push the U.S. dollar ever higher and could potentially wound the U.S. economy.

According to BCA analysts, every yield curve inversion phase since 1950 "has been associated with at least some stock market pain."

Even though weaker U.S. economic conditions may hurt the historically economy-sensitive tech sector, BCA analysts said the downside risk is greater for financials.

The S&P information technology sub-index is up 6.9 per cent this month, offsetting a slump earlier in the year to climb 0.6 per cent so far in 2005.

The S&P financials sub-index is up 1.4 per cent this month, but down 2.1 per cent so far this year.

The S&P/TSX capped financials index is up 4 per cent this month, but down 1.65 per cent this week, largely because of the beating CIBC shares took after the company announced that it's paying $2.4-billion to settle an Enron Corp. class-action suit. CIBC's stock price dropped more than 11 per cent this week.

© The Globe and Mail

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