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A few of the things that concern me are: Portfolio managers are very overweight the sector, analysts love the stocks heaping loads of “buy” ratings and zero “sell” ratings on the stocks and earnings expectations have gone through the roof just as the fundamentals look most challenging.

For example, the Wall Street Journal notes yesterday that since 2010 Wells Fargo revenue is essentially flat even though the shares have surged 70%. How? Well, they’ve been able to boost earnings through cost cutting (aka, firing staff, creating true earnings growth) and reducing their reserves for loan losses (bogus earnings growth).

Going forward, however, it won’t be nearly so easy for banks to create this same sort of earnings growth. The recent surge in interest rates means the refi boom is dead and they’ve already fired all their related, now extraneous personnel. So a major source of revenue has simply disappeared as has the corresponding cost-cutting opportunity. And loan loss reserves have already been reduced about as far as they can go so there’s no opportunity for pulling bogus earnings growth out of that hat.

In fact, banks may have to actually reverse course here soon and increase loan loss reserves as all the home equity loans made at the top of the bubble (2004-2007) are now coming home to roost. The way these loans work is borrowers only pay interest on the loan for the first ten years at which point they must start making principal payments, as well. In many cases this means the monthly payment triples. It should come as no surprise then that estimates suggest defaults could rise from 3% of loans in 2012 to 6% in 2014 as this occurs.

The technical bear case fits right in with the fundamental one. Yesterday the Banks Index formed a “shooting star” candlestick (bearish). Note that both RSI and MACD are diverging from the new highs in price:


And on the weekly chart we can see the index running into the 50% retracement of its financial crisis decline. RSI and MACD are also diverging from the recent new highs in price:


Because the banks typically lead the broader market this bears watching very closely.

DISCLOSURE: Long $FAZ for myself and for clients.