This Bank Stock Is Teetering On The Edge Of A Breakdown

Friday, July 8, 2016 - 7:30am

by Michael Kahn

The banking sector is down so much it almost seems risky to sell it further. However, to paraphrase the song, that's what trends are for.

While the S&P 500 has nearly recovered all of its losses from the Brexit panic, Capital One Financial (NYSE: COF) is down over 6% from its pre-Brexit close. Looked at another way, while the broader market index is not far off its 52-week highs, COF is much closer to its 52-week lows.

The question is, how long can banks stay low as the broader market holds firm?

If you believe in trends -- as you should -- then that is a question for the market to answer.

The trend in Capital One is down since its April rally high and down from its July 2015 all-time high. In the absence of strong evidence to the contrary, there is no reason to suspect COF's bear market is over.

And that means selling bounces can be a lucrative strategy.

Let's start with the big picture. As we can see in the chart, the bull market from 2009 ended in 2015 with a trendline breakdown and test of that breakdown that were both very clear if not textbook examples.

Next, the bear market from 2015 is also clear and, more importantly, still intact. The series of lower highs and lower lows, plus significantly lagging relative performance versus the market, make that an easy call.

The next chart is a closer view, and support from the lows of January and February is also clear. That level provided a platform from which the stock could bounce after the initial Brexit vote decline. And despite Wednesday's small upside reversal, that level appears quite vulnerable.

How so? We can start with volume, which fell during the bounce, as it usually does during an upside correction. A true reversal should see a surge in volume and price a few days after the low. That has not happened so far, and although there is a slight chance for it to occur, the window is closing fast.

A derivative of volume called on-balance or cumulative volume, shown at the bottom of the chart, paints an even worse picture. This indicator keeps a running total of volume on up days minus volume on down days. It hit a low at the start of the year, then moved a bit higher as the stock rallied, but has already hit a significantly lower low. Price has not done the same yet, but is likely to follow the indicator. On-balance volume is a proxy for money flowing into the stock, as well as for supply and demand.

So far, we have a weak stock in a weak sector in a shaky -- at best -- market. The next bit of evidence comes from the bond market, which has a great deal of influence over bank stocks.

With the benchmark 10-year Treasury note yield hitting a record low this week, the spread between short-term and long-term interest rates dipped to a nine-year low. Banks borrow at short-term rates and lend at long-term rates, so when the spread is narrow, so is their profit margin. It is hard to make a buck when your cost of goods is close to your selling price. And that does not even take fixed costs into account.

Even though bonds themselves seem to be a lousy investment, the trend around the globe is for government debt to offer negative yields. The United States is not there yet, but it is standing increasingly alone with positive rates. I am not economist, but that cannot be good for any economy and can choke the demand for loans.

Since there is a risk that COF will bounce off its nearby support levels, my plan is to wait to sell until the stock takes out that level. If it does break down, then there is a fairly clear path down to $50. And if it does not, then no harm, no foul.

Before closing, my research turned up some bullish arguments for investing in the stock from the fundamental side, including a low price/earnings ratio and a nice dividend yield, but the charts tell a different story for traders looking to make some quick profits.

Recommended Trade Setup:

-- Sell COF short below Wednesday's low of $59.66
-- Set stop-loss at $62.60
-- Set initial price target at $50 for a potential 16% gain in six weeks

There's one more way you can limit your downside risk even further, while increasing your profit potential. This strategy averages an annualized return of 123%, and you typically only risk a few hundred dollars per trade. It's worth taking a quick look here.

This article originally appeared on ProfitableTrading.com: This Bank Stock Is Teetering On The Edge Of A Breakdown​

Michael Kahn does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.