The Correction Is Likely Over...It's Now Time to Chase Beta

by: Alan Brochstein, CFA

Here we are in the middle of the summer already, and equities have returned nothing year-to-date. The bulls were wrong, the bears were wrong and the traders have been right (at least some of them). We aren't in that different of a place than I imagined we might be earlier this year. In fact, I described it fairly well in early February, when I discussed that 2010 is a year to "chase Alpha":

Will the market go up or down this year? Yes, but not much, at least not initially. Perhaps Beta begins to trump Alpha later this year, but I suspect a narrow range ahead... My guess is that the kind of market I envision will require us to be more opportunistic than normal, taking profits when they arise and jumping into herd selling situations.

Easier said than done, right? In the Top 20 Model Portfolio, where we can't chase Beta but only Alpha (due to having to be fully invested), we have enjoyed this environment, producing very strong y-t-d gains (but a lot of trades!). We have had a small-cap value bias all year, and we have seen 2 of our 20 slots get bought out.

While the lows were quite scary earlier this month, they do appear to be good lows for the correction. I now want to reiterate the call I had in May that we were in a correction and to discuss the better environment that I expect. I would like to see the S&P 500 take out 1111 (the close at the end of May) or even 1130 (the June high) to be really confident, but the 1011 low was the 38% Fibonacci retracement of the rally from March 2009 to the April 2010 peak. While we didn't get to "enjoy" a correction in the last bull market, they are normal. This one fit the text-book definition of not breaking 20%, though it sure left us with a feeling of deja vu as the selling became very indiscriminate.

So what now? Very early in the year, I mentioned a key level for the S&P 500 that, if broken, would signal a "new bull market". My guess is that we take out that 1229 level, which is just slightly above the 1220 level we achieved in April. It will take a climb up a wall of worry, but that's what stocks do. At this point, I am only guessing that we will take it out, but I am willing to bet that we try.

Rather than looking at the chart of the S&P 500 (feel free to check it out), I thought it might be more interesting to characterize the sectors. The S&P 500 chart is rather mixed, and I don't think the bullish or bearish reads are compelling. As I said above, we need to go higher to make the chart more compelling. I am encouraged that the 10dma finally crossed the 50dma for the first time since the "Flash Crash". This was confirmed by the Dow Jones Industrials, but not quite yet on the NASDAQ.

There are 10 economic sectors according to Standard & Poor's. Here is how they have performed YTD (click to enlarge):

Sp500 returns
Before I share my views of what the charts look like, as I did in May, I want to point out how varied performance has been. Six of the 10 sectors are down, while 4 are up. There is a pretty wide spread high to low as well. I believe that we can write off Healthcare to some very specific issues and Energy and Materials to a strong dollar. Tech has been a leader so long that it appears to be suffering from profit-taking that was actually evident in January. What can we say about the leaders? First, Industrials are doing well despite the strong dollar. I tend to pay more attention to smaller companies, and I sure have liked what I have been hearing from truckers, from distributors and other transportation companies in general. Also, if we are headed into the double-dip, why are Financials and Consumer Discretionary (the two sectors that were the worst by far in 2008) ahead of the game? That was a rhetorical question.

Healthcare as a sector trades - XLV. The chart is ugly - a descending triangle that suggests potential lows ahead. With that said, maybe not. It is oversold, but it has held the double-bottom from May and early July, which is a similar level to what held in September, October and early November. For the worst part of the market, it's not so bad.

Energy trades as XLE. Its low in July was well below the February low, but it's back to that level. I am not a big fan of the sector, but a weaker dollar could help. Again, for one of the poorer performing parts of the market, it looks corrective and not fatal.

Telecom Services doesn't have an SPDR ETF, but we can look at the two main stocks: AT&T (NYSE:T) and Verizon (NYSE:VZ). They are both locked in a sideways trading pattern for the past two years. Both of these stocks have seen their 10dma cross the 50dma. It's really not that relevant, so let's move on.

Technology (NYSEARCA:XLK) took out its February low, which was tested three times in May and June before failing, but it is 10% higher now. The 200dma has continued to rise, and we finally got back above it on Friday. This is the largest part of the market, so it's encouraging to see the rapid improvement in the chart.

Materials (NYSEARCA:XLB) are a small part of the market. Here too, the 10dma has surged above the 50 dma. In fact, the close was just below the 200dma.

Utilities (NYSEARCA:XLU) are close to breaking to multi-month highs. It's about time! With interest rates so low, these stocks seem awfully cheap. This is another tiny part of the market and not too important in assessing the overall health.

Financials (NYSEARCA:XLF), which are the first sector that is up on the year, have been sideways now for a year. If you look at the chart, you will see that there is no read here.

Consumer Staples (NYSEARCA:XLP) just cleared the 200dma and are also seeing the 10dma blow through the 50dma. They did that without Wal-Mart (NYSE:WMT) contributing, as it seems like Coca Cola (NYSE:KO) and Pepsi (NYSE:PEP) (with their international exposure) were the drivers. This is a small part of the market, but one that is filled with companies with strong brands. I like that investors are finally waking up to the value here. I described a very vicious rotation that coincided with the bottom as June ended, and this gives me some additional confidence that there was some capitulation that suggests a good low.

Consumer Discretionary (NYSEARCA:XLY) cleared its 200dma this week. Interestingly, it held its February lows during the correction. This just doesn't jibe with the negative talk we are hearing.

Finally, Industrials (NYSEARCA:XLI) also cleared the 200dma and also ended up holding the February lows.

So, as we look at the sectors, we find none of them are down year-over-year and the leaders held the February lows. On balance, my read-through is that though the S&P 500 remains below its 200dma (by just 1%), a lot of the market is through it already. In fact, if I take all 500 stocks, I find that just over 1/2 (267, or 53%) are above the 200dma.

A few other observations:

  • Small-Caps, despite the recent drubbing, are still ahead of Large-Caps
  • Value is still beating Growth

Tying it all together, I believe that the correction is likely over. While I am no economic bull (muddle along), it seems like there is way too much pessimism. Stocks look very attractive even if we haircut the earnings estimates. My read of the technicals is that the test is probably over. If we go just a little higher, I envision a feeding frenzy that will drive us towards the highs of April and perhaps a test of the 1229 level that I think is so important technically. It seems so far away, but we are just 11% from that level. 11% is a lot in the land of 3% yield on 10-year U.S. Treasury securities.

Disclosure: None