Sector Changes Show Bulls Are Losing Control

Includes: XLE, XLF, XLP
by: Cam Hui, CFA

It is always useful to look at sector relative changes once in a while, just to spot any phase changes or shifts in leadership.

When I first got into the investment business, a grizzled veteran taught me the basic principles of sector rotation. Early in the cycle, it's the interest sensitives that lead the way. Sector leadership rotates through the equity market spectrum until you get to the asset plays - the inflation hedge stocks at the very end of the cycle.

Financials are rolling over
The chart below shows the relative performance of the Financials compared to the S&P 500. Financials have two unique characteristics in this cycle. First, they are where the stresses in the system show up and therefore a good canary in the mine as to the health of the market. In addition, they are interest sensitives where central bank action and the expectations of central bank action manifest themselves. As the chart shows, the sector led the market up from the March 2009 bottom but is in the process of rolling over and is now testing a key relative support zone. If the sector weakens further, it would be an indication that the bears have taken control.

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Energy showing indecision
At the other end of the sector rotation scale, we have the Energy sector. This is also a useful indicator as much of the rebound has been driven by expectations of Chinese growth which has buoyed commodity prices. Energy stocks have been in a sideways pattern relative to the S&P 500 and arguably in a relative downtrend. This is what technicians call a consolidation pattern, which reflects indecision by Mr. Market.

Cyclicals are breaking down
What about the cyclicals? Cyclicals have also led the equity rally on expectations of a strong rebound. The chart below shows the Morgan Stanley Cyclical Index (CYC) relative to the S&P 500. CYC had been leading the market but recently failed at a relative uptrend line and is now testing a support level, indicating perhaps a change in market consensus that the economic recovery is on track.

The relative chart of the cyclically sensitive Dow Jones Transportation Average relative to the Dow Jones Industrials is also supportive of my conclusion. In fact, the Transports remain in a relative downtrend relative to the Industrials that dates back to September 2008.

Bulls losing control but bears not in charge yet
When I look at these charts, they tell me that the market is undergoing a phase change. Bulls are no longer in control, but the bears haven't yet taken command. This conclusion is supported by the behavior of Consumer Staples, a defensive sector that hasn't exactly been powering ahead on a relative basis.
The stock market appears to be, at best, undergoing a consolidating phase or basing pattern. Should it weaken further, it would indicate a major leg down in stock prices.

In the short run, however, Bespoke reports that the S&P 500 is 3 standard deviations below its 50-day moving average - a highly oversold condition. My inner trader tells me to wait for the oversold condition to clear up and watch the market reaction for signs of future direction.