July 23, 2008 at 12:51 PM EDT
Headwinds Index: How Long Can Financials Outperform Energy?

Two weeks ago, I introduced something I called the headwinds index, a simple ratio of financials (XLF) to oil (USO). It took another week for that index to bottom and the markets to rally, but since that bottom, financials have jumped 37% while crude oil has fallen 14% from its peak. The headwinds have turned into a strong tailwind, at least for the past six days.

The question, of course, is how long financials can continue to gain ground before a new long oil, short financials trade becomes too attractive to pass up. Several of my indicators suggest that the tailwinds are about to dissipate in the next day or two; after a strong opening, today’s developing gravestone doji also calls into question the staying power of the recent trend reversal.

At a minimum, I suspect the new tailwinds have gotten ahead of themselves. When they start to move back in the wrong direction, there is little reason to remain in the long financials, short oil trade past its useful life. As sailors are fond of saying, “tack on a header!”

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