The market is all about risk/reward, we know that as both investors and traders.

Though many don’t know it, sentiment – true sentiment – is at the core of the risk-reward valuation.

I’m watching two fundamentally different sentiment pictures as we head into the first three weeks of earnings.

One sector that’s climbing a Wall of Worry, and another that’s sliding down the Slope of Hope.

Let’s start with the latter since this sector is “up to bat” with earnings first.  The banks…

The “hot spots” in the earnings distribution table below are represented by the banks, SPDR S&P Bank ETF (KBE) and SPDR S&P Regional Banking ETF (KRE).  A lot has passed since last earnings season and the debacle that the market faced immediately before results hit the tape in April.

I’m not going to replay the details of March and April. We all know what happened.  I used the analogy that the market was likely to feel aftershocks less than two months ago when referencing the banks.  To put it simply, the tectonic plates have yet to settle in this sector.

Just a few weeks ago, we heard both Janet Yellen and Jerome Powell mention the likelihood that there would be challenges to the banking sectors.

Higher interest rates – which are clearly set to go higher – along with persistent instability in the economy and the real estate market are the problem.  The banks are at the epicenter.  It makes for another potential earnings season rumble that you need to prepare for.

Investors and traders have started to buy the banks, despite the clear risks.  

This is the “Slope of Hope”.

The Slope of Hope is a phenomenon that happens when optimistic sentiment combines with poor technicals.

Let’s hit the technical analysis first.

For the year, the banks – KBE and KEW – are two of the worst-performing sectors in the market.  The large banks are down 18% and the regional banks -29%.  By the way, note the iShares US Home Construction ETF (ITB) tearing its way to the top… I tagged that ETF as “bullish” four months ago.

In addition to tanking on their year-to-date performance, both banking sectors are trading well below their respective 20-month moving averages.  This identifies them as being in a technical bear market.

Additionally, both trade below their respective 200-day moving averages (MA200).  Until last week, both were also trading below their 50-day moving averages (MA50).  Note that I said, “until last week”, this is where a hint of sentiment comes in.

Just last week I was watching the sectors for a telltale sign of the market’s short-term sentiment.

Like clockwork, both the large and regional banks are seeing a surge of buying just ahead of the earnings kick-off on Friday.  

For the last eleven days, the KBE and KRE have rallied 6.6% and 6.8% respectively.  While it may not seem like a lot, it’s enough to tip the market’s hand that optimism is growing for a better-than-expected earnings season.  Put better, investors are starting to “hope” that the worst, or even bad case scenarios don’t play out.

It’s an old-fashioned “but the rumor rally” based on some optimistic sentiment.  The problem is that there’s another side of that trade, and we’re all familiar with it.

“Sell the news”

That’s what the sentiment trade sets itself up for.  A classic Sell the News moment, unless the banks sail through the next ten days with flying colors.  Are you ready to bet that’s going to happen?

Here’s why the risk/reward calculations now favor lower prices in the banks.

Wall Street speaks with its wallet.  It whispers its expectations in the form of buying.  Those whispers can come at any time, earnings season or not.

The fact that we’re seeing the KBE and KRE trade more than 4% higher as we approach earnings tells you something.  Wall Street is leaning into the banks with expectations that they hope will be met.

I often refer to this as being “priced for perfection.”  I think that’s an overreach at this moment, but here’s the catch… the banks now have Wall Street’s attention in the form of their investing dollar.

Remember that mention of risk/reward I made about 640 words ago (Thanks for sticking with me on this one)?

Well, short-term investors just took the risk of rallying ahead of the pending earnings report.  Unless they’re rewarded quickly, the banks are facing a new wave of selling.

If you’re in the banks at this moment beware.  A sector with this much inherent fundamental risk is already loaded for quick selling action in the wake of any earnings disappointment.  If I had positions – either long stock or call options – I would be operating with a short-leashed trailing stop approach.

In my case, I’ve opted to trade the potential selling pressure of a lackluster or disappointing earnings season for the banks by focusing on the weakest link, the regional banks.

With the KRE teetering on its MA50 AND the key round numbered $40 price (chart below) I’ve decided this is the better “sell the news” trade.  I’m eyeing the $41 strike for my put options trade.

Given the intermediate-term risks to the trade and my outlook, I’m opting for September 15, 2023, expiration options to give this trade time to play out.

As of Tuesday’s close, September 15, 2023, KRE’s $41 put was traded for $1.90 per contract.  This is $0.10 less expensive than the theoretical value of the option.  I like that “bargain”.

A move to $36 – the May lows for KRE – in the next 30 days would result in a theoretical price of $5.17.  That’s a 172% gain according to the trusty options pricing calculator.

I’m likely to take profits before then, but this risk/reward trade tilts the table in my direction given the current fundamental challenges the banks face.

Make sure you check back with me this afternoon as I dig deeper into the banking sector.  I’m going to name names on my Best and Worst in Breed stock list ahead of Friday’s earnings season kickoff.


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