Why An Upcoming Pullback Could Whack Financial ETFs

Tickers in this article: EWA IWB RYT VOX VYM XLB XLE XLF XLI XLP XLU XLV XLY
NEW YORK ( ETF Expert ) --U.S. stocks ( S&P 500 ) have packed on Olympic-sized gains through the initial eight weeks of 2013. Federal Reserve policy uncertainty aside, 6%-plus capital appreciation on low volatility is impressive by any measure.

The bulk of the run-up is attributable to industries tied to economic growth and enhancement. Sector ETFs that represent financials, industrials, technology and energy have been the most prominent performers. This is particularly remarkable when one considers the high probability of a sequester drag on the U.S. economy .

However, it is unusual for a diversified investment like SPDR Select Financials (XLF) to catapult 20% without a modest amount of resistance. It's even more uncommon for traders to ignore the temptation to reduce their exposure. In fact, rallies that go unchecked are often prone to temporary reversals that may erode half of one's unrealized profits.

It follows that a 5% corrective phase for the broader market could see XLF drop 10%. In fact, with XLF 12.5% above its long-term (200-day) trendline, you might even see a double-digit percentage drop.

Sector ETFs: Distance Above Long-Term Moving Average
NON-CYCLICALS%
Health Care Select Sector SPDR (XLV) 9.4%
Consumer Staples Select SPDR (XLP) 8.4%
Vanguard Telecom (VOX) 4.7%
Utilities Select Sector SPDR (XLU) 3.8%
CYCLICALS
Financials Select Sector SPDR (XLF) 12.5%
Industrials Select Sector SPDR (XLI) 10.5%
Energy Select Sector SPDR (XLE) 9.0%
Guggenheim Equal Weight Tech (RYT) 8.9%
Consumer Discretion Select SPDR (XLY) 8.5%
Materials Select Sector SPDR (XLB) 5.3%

To be frank, most of the cyclical sector ETFs have "gotten ahead of themselves." The selling that comprised the "worst two-day stretch" of 2013 did little to change that reality. Even the so-called safer non-cyclicals like consumer staples and health care are over-extended. Telecom and utilities are within an acceptable range, but they may be the most over-valued from a fundamental point of view.

Still, it is the financial segment that I am particularly concerned about. How many times can the media point to accommodative monetary policy and a real estate recovery? It is a desirable backdrop, no doubt. Nevertheless, a government-backed housing administration is not immune to upcoming automatic spending cuts. The U.S. Federal Housing Administration would not be able to process as many original loans or "refis."

There's more. Banks are still not lending at a sufficient pace to generate profits for investors. Excess cash that sits in the banks earns next-to-nada. Worse yet, even if banks begin lending like gangbusters, the value of those outstanding loans would decrease over the decade as interest rates rise.

Unless prevailing rates are lower than they are five to 10 years out, one can expect outstanding loans to hinder bank profitability. We might also expect demand for loans to decrease alongside any substantive increase in interest rates.