By Jim Donnelly, Olson Global Markets

In front of the release of August’s employment data this Friday, a series of economic reports released over the past two weeks has investors deeply pessimistic once again. As a result, the “run-to-safety” trade into U.S. Treasury securities pushed interest rates (across the yield curve) to new lows before a correction occurred toward the week’s end. Contributing to investor fears was a sense that the Federal Reserve has done most of what it could do, and most of what was expected of it to help nurse the struggling economy back to recovery. This wide-spread appraisal appeared to gel in the wake of last week’s central bank’s conference in Jackson Hole, Wyoming, and despite Fed Chairman Bernanke’s pledge to do even more.

Moreover, mounting pressure now appears to be shifting toward Washington to utilize more fiscal stimuli in front of the elections, a time that is considered too ticklish to get anything accomplished for many an incumbent.

It is no wonder that technical analysts are worried that a bearish “Head & Shoulders” pattern on the Dow Jones Industrial Average could play out to the downside. If it did, it would make investor sentiment even worse, despite last quarter’s better-than-expected earnings reports.

Since most analysts believe a legitimate turn-around in both the stock market and in the economy requires a healthy banking system, a renewed look at the Keefe, Bruyette & Woods U.S. Bank Index (BKX) is in order. With oversold conditions present, it is important to note that the BKX is now approaching a test of two key support areas that are very close to each other. The first is trend line support drawn off the lows since August 7, 2009 that sits at 42.75. The second is “channel bottom” support at 41.75 drawn off a series of highs and lows that date back to March 6, 2009. Although trend line support will change very little over the coming months, it is worth noting that “channel bottom” support does rise over time.

As a result, the 41.75 level holds great importance for the BKX and the overall condition of equity prices over the intermediate-term. If it holds and turns the Keefe, Bruyette & Woods U.S. Bank Index to the upside, a giant sigh of relief should occur for many investors. A solid break below, however, would be a big negative and a major concern.

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By Jim Donnelly, Olson Global Markets

Last week’s 511 point surge in the Dow Jones Industrial Average (DJIA) as well as the S&P 500 Index’s (SPX) 55 point gain caused both of those key barometers to close back above their respective “mid-channel” resistance levels. At the same time, bullish technical divergences were registered on each, suggesting more upside gains are likely heading into July’s “earnings season”.

What appears to be a leader in this surprising turn-around are bank stocks. The Keefe, Bruyette & Woods U.S. Bank Index (BKX) staged an impressive rally last week characterized by similar bullish technical divergences as well as a test of key downtrend resistance. Interestingly, both the DJIA and the SPX are now approaching similar downtrend tests.

Given that most analysts believe that a legitimate turn-around in both the stock market and in the economy requires a healthy banking system, one might surmise that a “breakout” to the upside in the Keefe, Bruyette & Woods U.S. Bank Index (BKX) would trigger similar upside “breaks” for both the DJIA and the SPX. The “breakout” level for the BKX sits very close by at 49.50. The DJIA and SPX “breakout” points sit a bit further above at 10,350 and 1,098 respectively.

It is important to point out, however, that all observations are based daily bar charts, which are short-term viewpoints by definition. Nevertheless, they all suggest that the current “summer rally”, if that is what it is, has a lot more pep left in it which might add a bit more sunshine to the upcoming earnings season.

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By Jim Donnelly, Olson Global Markets

After having formed a bullish reverse Head & Shoulders pattern (by breaking above “neckline” resistance at 47) on daily bar charts, the Keefe, Bruyette & Woods U.S. Bank Index (BKX) reversed lower and has just retested its neckline, this time as support. The key question now is whether its “neckline” will continue to act as support and fend off sellers, or give way to them instead.

If, in fact, this neckline can hold as support, resumption to an upward bias would likely occur, eventually targeting a test of the 78.50 area. That would, of course, represent a healthy increase percentage-wise from Friday’s closing levels and would likely improve overall market sentiment dramatically.

If, on the other hand, the 47 area fails to act as support, a break in the recovery spirit and drearier investor psychology could well emerge.

In the intermediate-term, larger banks may now face narrower margins as they conform to the newly passed financial reform bill. In addition, a flattening yield curve will likely restrict the banks’ ability to recapitalize itself over the near-term. Further, these banks’ credit card operations will likely reduce top line revenues because of their inability to accurately price their products to “risk”. Instead, the recently crafted credit card reform legislation will likely reduce margins and dampen credit extension to consumers.

Nevertheless, extraordinarily low interest rates should have a positive impact on asset values, helping to reduce provisions for loan losses. In addition, qualified borrows will clearly benefit from depressed interest levels helping them to grow their businesses.

In either event, the direction of the BKX should become resolved sometime soon with the 47 level squarely in focus.

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By Jim Donnelly, Olson Global Markets

Despite overbought conditions on the weekly time frame, the Keefe, Bruyette & Woods U.S. Bank Index (BKX) continues to push steadily higher following a break above key “neckline” resistance (at 49.50) of a bullish reverse Head & Shoulders pattern. This is an important observation since the “target” or “objective” of this pattern sits at the lofty level of 79.50.

In many ways, the BKX is emblematic of the equity markets in general since it appears to be “climbing a wall of worry” not seen for quite a while. A rise in bank stocks also encourages the tendency for a virtuous cycle of capital building to begin at the banks themselves. This is due to the likelihood that, in the future, banks will have the ability to issue common equity, preferred stocks and a variety of debt issues all designed to improve their capital ratios. In turn, this process should become the basis for a return to friendlier lending practices that should generate economic growth.

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By Jim Donnelly, Olson Global Markets

One of the curious things about this year’s correction phase of last year’s equity recovery has been the limited downside price action that has occurred thus far. This, of course, is in light of a number or worrisome forecasts that have been made recently. Students of Elliott-wave analysis, for example, are particularly gloomy regarding the direction and downside price potential of equities in general.

Fundamentalists continue to be concerned over the impact that potential commercial real estate write-downs might have on a number of regional banks, conjuring up thoughts of, perhaps, another big government bank “bailout”.

That said, it may be worth taking another look at the Keefe, Bruyette & Woods U.S. Bank Index (BKX) which continues to form what appears to be a bullish reverse Head & Shoulders pattern. True, it has taken a while for this pattern to develop, and it is equally true that the Fed has apparently begun the process of removing monetary stimulus with the largely symbolic raising of the discount rate.

Both of these observations are reasons to give pause to investors. Nevertheless, the prospect of removing “free money” may actually start bankers thinking about doing what bankers are supposed to do: lend money! This is an easy thing to say, especially given the deterioration of credit quality that has no doubt occurred in recent years.

Still, the bullish reverse Head & Shoulders pattern that appears to be forming on the BKX index suggests that a break above key “neckline” resistance at the 48.50 level, if it occurs, could give way to an impressive rise in that index up its lofty “objective” of 79.50. If such a break does occur, the recent corrective phase in equity prices may well come to an end more quickly than most expect.

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