Time to Take Profits

A pair of reports this week indicated that confidence has wavered in both the consumer and investor segments. For this reason and more, we think now is a good time to take some capital off the table and reduce risk in portfolios away from equities for the near-term.

FOREX: Risk currencies down against safer-havens, JPY biggest gainer.

Last week's sector update found that Technical Strength, a short-term measure of trending, was largely bullish among the eight S&P sectors that I follow weekly. It also noted some early signs of toppiness among market indicators. That situation has not changed in the past week, as we saw new price highs in the S&P 500 Index, but divergences among several indicators (such as new highs/lows) and sectors.

Technical Strength varies from a maximum of +500 per sector (strong uptrend) to -500 (strong downtrend), with values between -100 and +100 suggesting no significant directional tendency. Here's how we are looking among the sectors as of Friday's close:

By Bryan McCormick

The rally since the unofficial start of earnings season on July 8 has been led by technology, which is no surprise to anyone given the gains. But we do find something unexpected beneath the surface that requires some thought.

As of the close yesterday, 85% of stocks in the S&P 500 were trading above their 50-day moving averages. As shown in the chart below, 85% is high but it's not quite as high as the levels we saw in April and May. Consumer Discretionary has had a huge reversal from one of the weakest sectors to having 94% of its stocks above their 50-days. Financials are only at 72%, which is still well below the highs it saw in April and May. And Energy has gotten a nice bounce from 0% to 83% in a couple of weeks. We've seen quite a turnaround in just 10 trading days, and these charts highlight the turnaround well.

Starbucks’ (SBUX) announcement after the close Tuesday that it walloped the Street’s earnings expectations for its fiscal third quarter (as well as strong fourth quarter and fiscal 2010 earnings guidance) sent its stock higher, as shares of SBUX jumped nearly 10% in after hours trading.

But the earnings report isn’t good news for just Starbucks: it might be an indication that the country’s restaurant business, which was stung particularly hard during the recent recession as consumers slashed discretionary spending, may be poised to continue its strong rebound.

Sales appear to be bottoming: Per US Advanced Retail Sales data, seasonally adjusted retail sales appear to have bottomed in March with a 12.1% year-over-year decline. June’s 10.0% decline was the best showing since last November as the declines started to accelerate into this recession. Last year’s fiscal stimulus remains as a near term challenge for retail comparisons.

"Spoon full of sugar helps the medicine go down." And that may be the case with Friday’s unemployment numbers. The headline numbers were a worry, yet the agency reported in a separate survey that the pace of job losses appears to have slowed substantially. In its good news-bad news report, the Bureau of Labor Statistics said that employers shed 345,000 jobs in May, far fewer than the 500,000-plus expected.

There has been little change in the utilization (the measure of supply and demand in the securities lending market) of the S&P500 over the past month, there has however been a big upswing in utilization of the consumer discretionary sector, which is up 6.8% to 21.9% . Despite the rise in consumer discretionary utilization, the consumer staples sector’s utilization has seen a decrease in utilization of 5.7% to 8.1%.

From our weekly Sector Snapshot report at Bespoke Premium, below we highlight the percentage of stocks above their 50-day moving averages in the S&P 500 and its ten sectors. As shown, 77% of the stocks in the S&P 500 remain above their 50-days, which is still a high breadth reading compared to levels over the past year. The ability for this indicator to remain above 50% will be a good measure of the sustainability of the current rally.

The Energy sector has the highest percentage of stocks above their 50-days at 97%. The next best sector is Materials at 86%, followed by Health Care at 85%. Telecom (56%) and Consumer Discretionary (59%) currently have the weakest breadth readings.

Congratulations to those who have been on the right side of this market's relentless rally. Regardless of the persistent questions as to whether the recent uptrend has been just another bear market rally or the origins of a sustained bull market, your gains are real.

Now it's time to protect them.

I mentioned last week that I was seeing a group of AplhaDEX ETFs on the TradeRadar Trend Leaders list. I was not at all familiar with the name, but since they were performing so well I felt they deserved a look. It turns out they are managed by First Trust and they are intended to provide superior performance by taking fundamentals into account when selecting the stocks that make up each style or sector portfolio.

Index Universe first wrote about these ETFs way back in 2007 (here's the link from Seeking Alpha).

The quality of this rally is low…. The move is powerful but the underlying raitonale weak.

Below we highlight our charts that show the percentage of stocks trading above their 50-day moving averages for the S&P 500 and its ten sectors. As shown, 87% of stocks in the S&P 500 are currently above their 50-days, which is the highest reading over the last year. Financials, Industrials, Technology, Consumer Discretionary, and Materials are also at their highest readings over the last year. Energy, Consumer Staples, Utilities, and Health Care are the sectors (all defensive) that have yet to take out their one-year highs. These high breadth readings are positive for the longer-term outlook of the rally, but they also indicate overbought conditions in the short term.

Generally speaking, I see myself as a value investor. Why then, am I so often looking towards retailers and generally consumer facing businesses for my best investment ideas (see: A Retail Reversal and Irrational Retail Valuations)? After all, many of the best retail stocks are those that rely on growth to provide shareholder return. And, in the case of liquidation, the bulk of their assets are held in inventory and property* that are rarely liquidated at full value. Then again, Warren Buffett, a value investor if there is any, has made serious bets on consumer product and retail businesses like Coca-Cola (KO), CarMax (KMX), Wal-Mart (WMT), and Costco (COST).

* To be completely fair, significant value in property can often be unlocked to stave off bankruptcies or generate tremendous shareholder return through sale-leasebacks which generate plenty of cash or potentially attracting buy out firms interested in getting a piece of the real estate.