Will the Banks Take a Breather?

Finishing in overbought territory for four days in a row, the Financial Select Sector SPDRS ETF (NYSE: XLF) has been a way for active investors to participate in the renaissance in bank stock speculation in the opening scenes of 2012.

And from regional banks like US Bancorp (NYSE: USB) that have been trading consistently in bull market territory since late November to money center titans like Citigroup (NYSE: C) that have been toiling away in bear market territory for months, it seems as if every financial stock has their fare share of newly devoted fans.

Based on the recent strength of these stocks, and the fact that so many continue to trade at levels where, historically, short-term rallies have been difficult to sustain, exchange-traded funds representing the sector have earned significant ratings downgrades. In addition to funds like XLF, the two-to-one leveraged ProShares Ultra Financials ETF (NYSE: UYG) and the three-to-one leveraged Direxion Financial Bull 3x Shares (NYSE: FAS) have also earned “consider avoiding” ratings ahead of trading on Friday.

How can traders take advantage of the potential for underperformance in the financials in the short-term? Active investors may prefer to look to the inverse and inverse leveraged ETF market for funds like the ProShares UltraShort Financials ETF (NYSE: SKF) and the Direxion Financial Bear 3x Shares (NYSE: FAZ), especially if buyers remain persistent, pushing the banks deeper into overbought territory. Both SKF and FAZ have earned “consider buying” ratings of 9 out of 10, and have significant, short-term positive edges.

There is every possibility that any near-term selling in the sector represents simply profit-taking rather than a return to major new lows. The XLF, for example, is up more than 12% since its last pullback in mid-December. And given the performance in the banks over the past several months, it would not be surprising if traders were feeling a little more eager than average when it comes to locking in any short-term gains.

Note that J.P. Morgan Chase (NYSE: JPM) is scheduled to report quarterly earnings on Friday.

If you like stocks, then you’ll love 7 Stocks You Need to Know. Click here to learn more.

David Penn is Editor in Chief of TradingMarkets.com