Monday, September 2, 2013

Market conditions & sector ETFs

Syria dominated market action last week on very low volume.  However, as I posted on twitter, I believe Syria is partially a "smoke screen" for what's really bothering this market.  And that is the threat of higher interest rates due to the probable reduction in Fed asset purchases and the possibility of the central bank losing control of the yield curve.  Throw in the probability that Larry Summers will be the next Fed chairman and you have what the market perceives as a "double whammy".  Summers, perceived to be a monetary hawk (although there is really no evidence this is so) and the Obama administration's pointed expression for a stronger US Dollar, are real concerns for this market.

I decided that, at this juncture, it would be appropriate to break down the stock market by technically analyzing sector Exchange Traded Funds.  ETF's are an excellent way to diversify within any particular industry group while also positioning oneself correctly in the business cycle (provided you can see thru the central bank distortions to understand where we are in the business cycle).  By comparing the relative strength or weakness of these industry groups to the broader S&P 500 this methodology can assist us in correctly assessing where we are in the business cycle as well as taking advantage of institutional money flows in and out of these industry groups.

Let's start with a broad overview.  Here's a weekly chart of the S&P500:

(click on chart for larger image)
The blue dashed trend line is drawn from the historic March, 2009 low.  The chart is impressive!  However, we are sporting a slight divergence on the weekly RSI momentum indicator (top panel).  First significant support on the weekly chart is the 1550 area.  It's worth noting that 1600 could also provide some short term psychological support. 

Regardless of momentum divergences, there is nothing on this chart that suggests we are presently in the midst of anything more than a "garden variety" correction.

Here's the Financial Select Sector ETF (XLF) which is comprised of the money center banks (JP Morgan Chase, Wells Fargo, etc.), American Express and Berkshire Hathaway:

(click on chart for larger image)
XLF had been providing the leadership as this market moved higher since last December but has recently broken down under its 50 day moving average as well as a support line drawn from last November's lows.  Notice the "bear flag" pattern that led to a breakdown of the ETF below long tern support.  We seem to be presently forming another "bear flag" at this time.  The price of the ETF is underperforming relative to the broader S&P (bottom panel).  It's a positive when the money center banks lead the charge higher in a bull market and conversely, it's a negative when they relinquish that leadership.
Here's the S&P Retail Index (RLX) which is comprised of major retailers such as Dollar Stores, JC Penney, Albertsons, Office Depot and Target:

(click on chart for larger image)
RLX is presently trading under its 50 day moving average and is flirting with penetrating a long term support line drawn from the November, 2012 lows.
Here's the Technology Select Sector ETF (XLK) comprised of companies such as Apple, Microsoft, AT&T, Verizon, Hewlett Packard and Visa:
(click on chart for larger image)
 XLK had been outperforming the S&P for most of August but that performance has flattened out and the ETF is trading below its 50 day moving average.
Here's the Consumer Discretionary Select Sector (XLY) comprised of the likes of Comcast, Walt Disney, Amazon, Ford, Macy's and Bed Bath and Beyond:
(click on chart for larger image)
XLY's chart pattern is similar to XLK but it's performance has been flat in comparison to the S&P for most of the summer.
Here's the Industrials Select SPDR ETF (XLI) which tracks a basket of industrial stocks such as Cummins, General Electric, 3M and John Deere :
(click on chart for larger image)
XLI is also trading below its 50 day moving average and is caught between a "rock and a hard place".  The gap formed above the present price action will be formidable short term resistance while it is also sitting on support at about $44.00.
Here's the Energy Select Sector SPDR (XLE) comprised of oil service and exploration companies such as Exxon, Chevron, Schlumberger and Apache:
(click on chart for larger image)
XLE bounced off Fibonacci support in mid August thanks in large part to Syria but is stuck in an area of significant resistance from the July highs.  It appears to be the major contributor to the strength of the broader S&P for the past two weeks (bottom panel).

Below is the iShares Dow Jones US Home Construction ETF (ITB) comprised of companies such as Lennar, Pulte Group, KB Homes, Sherwin Williams and Toll Brothers:
(click on chart for larger image)
I've superimposed the spot price of Lumber on the chart which predicted the decline in the home building complex by as much as two months (red arrow).  This is an excellent example of how technical analysis trumps fundamental analysis.  In late March, while Lumber was taking a nose dive, the street was absolutely aglow with the prospects for the home builders going forward.  How did Lumber know interest rates were going to soar in May?  Ours is not to reason why ...  The bottom line here is that home building, which has been the "poster child" of this recovery, is floundering.
Here's the Material Select SPFR ETF (XLB) which tracks the performance of companies such as DuPont, Monsanto, Dow Chemical and Praxair:
(click on chart for larger image)
XLB has been outperforming the S&P since July and that out performance has accelerated in the past month.  Unlike the ETFs above it is still trading above it's 50 day moving average and it has room to the downside before it bumps into support.   People are obviously positioning themselves for the expected pick up in global economic growth which some economic reports seem to be intimating ("intimating" being the operative word).
The following are defensive sector ETFs.  These are ETFs made up of equities investors usually flee to if they still want to maintain a presence in a down or weakening stock market.  They are representative of the types of companies that produce products or provide services that people need and use, regardless of economic conditions.
Here's the Utilities Select Sector ETF (XLU) representative of companies such as Pacific Gas & Electric, Consolidated Edison and Dominion Resources:

(click on chart for larger image)
Utilities sold off hard in May as the prospect of higher interest rates became apparent and the under performance to the S&P is clearly evident in the lower panel.  However, that relative performance since June has been flat.  At the same time, the ETF has been in a tight trading range while sitting on support.   
The dominant view in the marketplace is that interest rates have nowhere to go but up.  While I tend to agree, I'm not quite as dogmatic in that position as others on the street for a number of reasons I've addressed in numerous commentaries and "tweets".  Utilities will soon tell us the short term direction of interest rates.
Here's the Healthcare Select Sector ETF (XLV) made up of companies such as Johnson & Johnson, Pfizer, Merck, Humana and Baxter international:
(click on chart for larger image)
XLV has been sporting relative strength (bottom panel) since May but has formidable gap resistance in the $50.00 area and is still trading below its 50 day moving average.  At the same time, it seems to have found Fibonacci support.  It, like XLI above, is in a tight trading range.
Here's the Consumer Staples ETF (XLP) comprised of companies that produce products or provide services that people need no matter how good or bad economic conditions are - Proctor and Gamble, Phillip Morris, WalMart, CVS Caremark and Costco:
(click on chart for larger image)

XLP has bounced off of support and is trading considerably below its 50 day moving average.  It's also been seriously under performing the S&P 500.  On the face of it, one would think that this is unusual given that the more economically sensitive sectors have been underperforming (RLX, ITB, XLK, etc.).  However, I believe there's an important message that XLP's chart is telling us.  If market participants were truly fearful that the economy is turning over, XLP, XLV and XLU's price relative to the S&P would be much different.  In fact, I would posit a fact and a thesis for my readers consideration :

1. Although it is undeniable that stocks have suffered short term technical damage, for the most part, major support has not been broached in almost all of the sectors.

2. The fact that the defensive sectors have not responded more positively to the recent market weakness tells me that we are simply in a normal correction in an ongoing bull market.

Now, here's my caveats:

1. Home building (ITB) needs to shrug off it's interest rate induced weakness and resume it's uptrend.  This will provide the necessary validation for the position articulated by many that the US economy can withstand sustained higher interest rates.

2. I've already beat this horse before but we need to see the inflation rate start to head higher.  While it would be premature to start addressing the possibility of a "liquidity trap" the present year over year inflation rate of 1.2% is too low and is speaking to a weak economy.  In such an environment, I would propose that a "hiccup" in the economy could find us in a deflationary situation.  And deflation + QE = liquidity trap!  Indeed, the price action of commodities and gold are continually warning us of this possibility.

Anyone who follows the market knows we're going to be in for a rough ride in September.  The big event is the Fed September 17-18 meeting where the consensus seems to indicate that Bernanke and company will start an incremental process of taking away the punch bowl.  Market reaction to such a policy decision will tell us much about the true condition of our economy and the financial markets.  And, of course, we have a new chapter in the "fiscal follies" brewing in Washington as it appears Dems and Republicans are already positioning themselves for budgetary brinkmanship.  The German election on September 22nd will see Angela Merkel as the winner but the configuration of the Bundestag will be watched closely as her effectiveness could be impacted if her coalition majority is upset.  I'll be addressing these issues more specifically as we get closer to these events. 

That's it for now.  Thanks for your support and have a great week!