The ‘canary’ is dead – Is it time to get out of the mine?

by TraderEd

Some analysts have called Merrill Lynch a “canary” because movements in Merrill’s share price tended to be a leading indicator for what might happen to financial stocks and the stock market as a whole, much like the canary in a mine shaft that warned miners about potentially poisonous gas in times past. But now that Merrill Lynch has been sucked into Bank of America, who will be the next canary?

Of course, the financial sector is more like a minefield, and the mines are still going off with the bankruptcies and takeovers and bailouts among the leading bastions of U.S. financial markets still taking place – and another potentially ominous weekend coming up without a finalized government bailout plan (as of this writing).

It doesn’t make a lot of difference anyway because the direction a lot of people might prefer to trade – short – has been taken away for something like 800 financial firms by government decree, at least for a while. Banning short selling has only occurred a couple of times in the distant past, and it didn’t keep the stock market from dropping further then.

Will the government’s proposed high-risk financial package work? No one knows. It certainly is not a bailout for the tax-paying public but more like a handout to the greedy Wall Street executives and cronies of government officials who made the decisions that caused the financial crisis in the first place. It seems impossible that even the U.S. Treasury, with all its taxpayer resources and ability to print money, can absorb all the debt and faulty instruments still out there. And giving Treasury Secretary Henry Paulson “non-reviewable authority”? Scarey.

With a lot of bad news still likely to come, the government has found its pigeons instead of canaries to pay the bill ultimately. Under these conditions, who wants to be a buyer of financial firms these days?

Warren Buffett apparently is one, putting $5 billion into Goldman Sachs with the possibility of adding another $5 billion to that. But he is a pretty smart pigeon known for wise investing. It took changing Goldman from an investment bank to a bank holding company and some terms that are almost unbelievably beneficial to Buffett to attract his money. Makes you wonder how bad the situation really was at Goldman, which had indicated earlier it had sidestepped much of the sub-prime mortgage mess.

All of this turmoil made me curious about how the financial stocks look on the charts now. No use looking at the charts for Fannie Mae or Freddie Mac or Lehman or AIG or any of the other troubled firms. And no use looking for trading opportunities on the short side. So we’ll look only at Goldman and Morgan Stanley, the last two investment banks, which both converted to bank holding companies this week to gain access to a flow of incoming money.

As the VantagePoint charts illustrate, the picture is not too bright for either Goldman or Morgan Stanley – in fact, VantagePoint’s predicted medium-term moving average crossed below the actual medium-term moving average on Sept. 10 (arrows), a bearish indication before the value of the stocks were chopped nearly in half or more. The price action hasn’t been pretty since then, with wide swings in prices almost daily.

With Buffett’s injection of funds, Goldman is showing signs of turning up and making a bullish upside moving average crossover. However, after reaching the 50% retracement area of the steep September downmove, Morgan Stanley appears to have turned softer again.

But it’s certainly not clear what the outlook is for any of the financial stocks in the current environment