The Curious Case of the Stubborn Market Leaders

In this bear market it is difficult to find chart patterns that look attractive. For more details on this mystery chart (click to enlarge), read on…

Leadership changes during bear markets
Bear markets are periods of catharsis. They serve to cleanse the excesses of the previous market cycle. That’s why, as a general rule, technicians look for a change in sector leadership to mark the beginning of a new cycle.

During the early 70s, the Nifty Fifty was the dominant leadership. The late 70s saw inflation hedge vehicles such as the oils and golds lead the market. The 80s was the era of Japan and consumer oriented stocks (remember the LBO boom, which was focused on many of the consumer names?) The bull of the 90s was fueled by technology, led by Internet stocks. The latest bull was led by the emerging markets and commodity producers, which were viewed as levered plays on the growth in China and other emerging market economies.

Watching for the leadership change
To watch for changes in leadership, technicians often use relative price charts. As an example, the chart below (click to enlarge) shows the NASDAQ 100 relative to the S&P 500 during the Tech Bubble and its aftermath. The NASDAQ peaked in March 2000 and fell, on an absolute basis and relative to the S&P 500. On a technical basis, the NASDAQ 100 tested the relative uptrend line in January 2001 and broke below it decisively a month later.

Comparing the above chart to today’s market, the S&P 500 peaked on October 9, 2007 at 1565.15. Over a year later, after the market peak, the chart below (click to enlarge) shows the relative charts of the Energy Select Sector SPDR (XLE), which is a proxy for the commodity stocks, and the iShare MSCI Emerging Market Index to the S&P 500 (EEM).


Surprise! Surprise! The leadership is still intact. While it is true that the EEM/SPX line is now testing an uptrend line, these charts look very healthy by comparison.

What about the leaders within the leadership? The chart below (click to enlarge) shows the Internet HOLDRs (HHH) relative to the NASDAQ 100 at the peak and after the peak of the Tech Bubble. Internet stocks, as represented by HHH, peaked in December 1999, a few months before the NASDAQ actual peak, and were in substantial decline afterwards.


Stubborn leadership
By contrast, we come to the mystery chart at the beginning of this post, which represents the chart of XLE relative to EEM. Energy stocks had been in a basing pattern compared to emerging markets for several years. They began a relative uptrend in October 2007 and staged an upside breakout in October 2008.

What about the economy?
Right now, the world is swamped by deflation. China recently reported very disappointing 4Q economic growth.

However, I continue to believe that we should still give inflation a chance given the enormous policy consensus to reflate the banking system and the US consumer. As a result, the USD is at risk of a substantial decline, with the GBP as the canary in the mine. Well, with the pound sterling now falling, that canary is now falling over.

Listen to the tale of the tape
Despite the sense of panic out there, the market tape is telling us that the situation is starting to stabilize. Housing stocks have stopped falling and they are now forming a base. The Baltic Dry Index, which had been in freefall, is showing some minor signs of recovery.

If we listen to the tale of the tape, we have the unusual situation where the previous leadership of commodity producers remains intact. With that in mind, I am still inclined to give the inflation trade the benefit of the doubt for now.

What to do?
My inner investor tells me to nibble away at energy and commodity positions, as this kind of analysis has a tendency to be early by as much as a year or two. My inner trader, on the other hand, also tells me to put on the long XLE/short EEM trade on any kind of decent pullback.

Comments

[Tradememe:]

Does a recovery always need a change in market leaders ? Perhaps, this one will be different. We should not be too dependent on rule of thumbs.

Jan 27 07:36 AM

[ROLEX18K:]

In times when Warren Buffett is down 40% nothing will help you, sell this market short together with Mr.Buffett.
Buy it back (DJIA) at 3000 points.

Jan 27 09:00 AM

[Bruman:]

How did you decide to use that trendline in the NASDAQ 100 vs SP500? It seems like a strange time period to use.

Jan 27 10:53 AM

[lbsterling:]

Despite not believing much in charts, I agree with your conclusions.

Jan 27 10:54 AM

[Jolly_Rancher:]

The problem with your conclusions is your confusion. The dramatic rise in energy and other commodity prices is really what brought on this crisis. The housing and credit crunch are merely incidental. Every commodity spike, will be followed by more recession and deflation, leading to lower commodity prices. The consumer is tapped out and cannot purchase high priced energy. He will cut back on other purchases; he will ditch the SUV for smaller car. He will turn off the A/C in summer. We may be at peak oil, but that doesn't mean that the price of oil necessarily has to go up. There's more demand destruction possible "than are dreamt of in your philosophy" Mr. Hui.

Jan 27 11:43 AM

[Crocodilian:]

Author Cam Hui always has creative ideas about looking at data, this is no exception. But I guess I just don't know what to make of the movements in a chart of an arbitrary relationship. What if the chart of the relationship:

(Polish Zloty)
divided by
(Saudi Riyal - Gold)

forms a double bottom? Does that mean what a double bottom in, say, Exxon Mobil, does? My guess is that it doesn't.

Jan 27 12:24 PM

[adAstra:]

I think the point is that the chart of XLE exhibited bubble behavior to the upside and currently, bounced off the trendline. Projecting into the future, XLE should be over-correcting to the downside.

While it might prove profitable to invest in XLE near the low of the over-correction, the article also discusses sector leadership. My take is that a small position in XLE-related stocks would be profitable and allow for diversification, but the focus should be on investing in the next market leader.

A cheap dog is still a dog.

Jan 27 03:25 PM

[Moon Kil Woong:]

Interesting article and comments. Linking energy to emerging markets is a bit funny. You are comparing large caps to small caps. So without factoring that out the comparisons may be a function of that.

Small cap to large caps have a well know history of outperforming small caps except in a few instances. Expecially since you are comparing emerging market small caps. The same argument goes with the NASDAQ 100 vs S&P 500 and probably the Internet comparison (not sure of the exact basket). In every case, your comparison is larger companies compared to smaller. So I am not surprised to see the chart conclusion in the least. Because of this, it seems not to prove the leadership issue.

Charts can be misleading. Especially if you are assuming something but not factoring other reasoning (Occam's razor applies).

Jan 28 12:31 AM