What is the first thing you do when buying a car? You probably pop the hood and take a look at the engine. Why?

Just because the body looks fine doesn’t mean the engine is. Oil leaks and all sorts of gnarly conditions can hide under the hood.

Similar to a car, there’s always an “engine” driving the market. Most often, this engine is a certain sector, a sweet spot of the economy.

In the late 1990s, this sector was technology. Technology took the leadership role and propelled the Technology Select Sector SPDRs (NYSEArca: XLK), Nasdaq (Nasdaq: ^IXIC), and even the Dow Jones (DJI: ^DJI) and S&P 500 (SNP: ^GSPC) to never before seen highs.

As technology lost its momentum, real estate stepped up to the plate. Real estate ETFs like the iShares Cohen & Steers Realty Majors (NYSEArca: ICF) and iShares Dow Jones US Real Estate ETF (NYSEArca: IYR) delivered performance while stocks were lagging.

Soon it became clear that the real estate boom wouldn’t be possible without the “generous” help of banks and other lending institutions. Along with property prices, financial stocks started to soar.

In fact, the financial sector continued to push forward even as the real estate market cooled. The leadership torch over the past ten years was passed on from technology to real estate and from real estate to the financial sector.

From villain to hero

At the height of the financial crisis, financials were viewed as a money pit with no recovery in sight. Shortly before the March lows, Washington Mutual, the largest bank ever to become illiquid, foreshadowed a gloomy future.

It was exactly at that time, when the ETF Profit Strategy Newsletter temporarily suspended its bearish outlook and recommended to buy long and leveraged long ETFs via the March 2nd Trend Change Alert. The financial sector was singled out as the biggest beneficiary of the upcoming rally.  The Ultra Financial ProShares (NYSEArca: UYG) was up as much as 330% by the middle of October.

Every major trend change over the past several years was spearheaded by the financial sector. As a group, financial stocks led the Dow Jones (NYSEArca: DIA) and S&P 500 (NYSEArca: SPY) towards their all-time highs.

The financial sector peaked before the broad market and declined harder and faster in 2007 and 2008 before leading the advance from the March lows.

Needless to say, a look at the financial sector today provides invaluable clues about the market’s direction. So, what are financials signaling?

What’s the leadership doing?

A look at the Financial Select Sector SPDRs (NYSEArca: XLF) shows that financial stocks peaked on October 14th. The direction since has more or less been down. On October 26th, XLF fell below its 50-day Moving Average. Since then, XLF has closed below the MA about 90% of the time and sits clearly below it right now.

The same is true for the Vanguard Financial ETF (NYSEArca: VFH) and iShares Dow Jones US Financial Sector ETF (NYSEarca: IYF). But wait, there’s more!

The SPDR KBW Bank ETF (NYSEArca: KBE) has been lingering below its 50-day MA for over 30 consecutive trading days. The main components of KBE are Bank of America, Citigroup, JP Morgan Chase, and Wells Fargo; the same banks that led the 2008 meltdown.

Where’s the backup?

Right now, only the safest of safe stocks are the focal point for investors.  Blue chips have outperformed most, if not all other sectors over the past several weeks. Some compare this type of action to the general charging ahead while the troops are falling behind.

Just a few weeks ago, we had some stocks emerge as generals from the earnings season. Apple for example rallied to new all-time highs following its earnings announcement. At times, Apple rallied even though the Nasdaq (Nasdaq: QQQQ) lingered.

The last few days, however, Apple weakened and fell below its 50-day MA. Apple was demoted from general to soldier.

How important is the moving average?

Some swear by moving averages, others prefer to ignore them.  So what’s the significance of the MA?

When you boil it down to the basics, the MA is basically a trend indicator. As long as indexes stay above the MA, the trend is up. Once they turn down, the trend may have changed. As with any other indicator, the MA is not foolproof. There’ve been numerous times in the past when the MA gave a false signal.

Other factors to be considered in addition to the MA are:

1) Stocks rallied 65% in less than nine months.
2) Based on buying climaxes, stocks are moving from strong hands to weak hands.
3) Volume has been contracting for weeks and has reached some of the lowest levels in 2009.
4) Based on long-term valuation metrics, stocks are overvalued.

The curious case of valuations

Valuations are the lynchpin for the market’s long-term direction. Over the short-term, perceived value may, and will, deviate from the actual value. This is not the case over the long-term. The market has a memory like an elephant and will brutally correct cases of gross overvaluation.

We’ve seen this in the 1930s, 1940s, 1950s, 1970s, and 1980s. A partial reset occurred in 2000 and 2009. Why only partial?

Unless earnings increase astronomically, the market has to drop a certain amount before fair values are reached. How much is a “certain amount?” This can’t be gauged by a flat number of points or percentages, but rather by valuation metrics, such as P/E ratios and dividend yields.

When P/E ratios and dividend yields drop to their respective rock-bottom levels – which are indicative of a valuation reset to fair value – the market has fallen enough. At times, this takes a very significant decline in prices. Just as the human body is not healthy unless its temperature clocks in at 98.6 degrees, the stock market has not reached a true market bottom unless valuations clock in at rock-bottom levels.

Even in March, when the Dow declined to 6,500, dividend yields and P/E ratios were still hovering way above the rock bottom levels indicative of a major market bottom.

Today, P/E ratios are the highest they’ve ever been (according to Standard & Poor’s), while dividend yields are close to their lowest reading in decades – exactly the opposite of what you’d want to see. 

Today the S&P 500 trades at 86x annual earnings. This means, if you add up the companies annual profits and multiply it by 86 you arrive at the stock’s/index’s price. Would you lend money if you knew it takes, based on current facts, 86 years to be repaid? If you answered no, you may want to reconsider owning stocks at this time.

The ETF Profit Strategy Newsletter performed a detailed analysis of historical P/E ratios, dividend yields, and cash reserves plotted against today’s prices.  This analysis allows investors to mathematically pinpoint the target range for the ultimate market bottom. The actual results and future implications are available in the November issue of the newsletter.