Heading into earnings season, the broad equity market is still subject to selling pressure from rising Treasury yields. However, investors aren’t completely without options as there is meaningful relative strength in some quarters of the market. In today’s report, we’ll examine the market segments which are especially vulnerable to negative earnings surprises, as well as the areas of relative strength in the energy and utility sectors.
Observers witnessed an indecisive stock market on Tuesday, as investors continued to worry about rising interest rates, emerging market weakness, and the potential impacts of Hurricane Michael in Florida. Meanwhile, the major indices fluctuated in a narrow range and closed little changed in the latest session.
Below the market’s surface, however, there are still signs that the sellers have the advantage for now. On the Big Board, new 52-week lows outpaced new highs by a 5-to-1 margin. On the Nasdaq, the new lows outnumbered the new highs by 6-to-1. This tells us that the incremental demand for equities remains weak and that the stock market is therefore vulnerable to additional selling pressure in the immediate term.
Shown here is a graph of the cumulative NYSE new 52-week highs-lows. As I’ve emphasized in recent reports, until this key indication of demand reverses its recent decline, investors should maintain a defensive short-term position.
Small cap stocks are still among the weakest performers right now. The Russell 2000 Index (RUT), below, is a case in point. Although there have been three tests of the psychologically important 200-day moving average this year (below), RUT until now has never broken this highly regarded trend line. RUT is currently testing the 200-day MA and is on the verge of breaking it, however.
While a brief technical rally from here is possible, based on the temporarily “oversold” nature of the small caps, it’s likely that the 200-day MA will be violated at least once before this latest correction has ended. I base this prediction on the observation that the incremental demand for equities is still quite weak as there are far more stocks making new 52-week lows than highs on both major exchanges.
The good news is that the current weakness in the small caps isn’t fundamentally based, but is mainly technical in nature. The powerful rally in the small caps this past summer put them in a vulnerable condition for a pullback since the small caps rose too far, too fast which meant that the RUT became over-extended from its 200-day trend line. Whenever this has happened in the past, there has been a pullback which puts the RUT closer in line with the trend line.
It can also be argued that a sharp break under the 200-day MA in the Russell 2000 Index could facilitate capitulation among the bulls and create the conditions necessary for the market to bottom. In Tuesday’s report, we examined evidence which suggested that individual investors were far too optimistic on the intermediate-term outlook for equities given the currently weak technical environment.
For instance, the latest sentiment poll from the American Association of Individual Investors (AAII) revealed that many investors had actually increased their bullish bias on stocks last week despite the latest internal weakness and rate-related selling in some sectors of the market.
The latest AAII survey showed that 46% of members were bullish, compared with only 25% bearish. As I stated in the previous report, market bottoms are nearly always accompanied by a spike in the percentage of bears and a drop in the bullish percentage. According to the latest AAII poll, the opposite of this happened. This suggests there is still some downside potential in stocks before the bottom is finally in.
Not all the news for the broad market is bad, however. On the relative strength front, the energy sector clearly enjoys an advantage right now. Shown here is the December crude oil futures chart, which is the reason for the strength behind the energy stocks. This is in spite of the fact that the U.S. dollar index is also strong right now. Normally, oil prices are negatively influenced by a strong dollar, but the current energy market strength is mainly driven by supply and geopolitical concerns.
Continued strength in the crude oil price will also help bolster the near-term outlook for oil and gas equities, which in turn will provide some potentially attractive safe-haven options for investors during the October internal correction. This can be seen in the strength of the NYSE Arca Oil Index (XOI).
Among the top performers in the energy group right now are Marathon Oil (MRO) and ConocoPhillips (COP). Shown here is a relative price strength comparison of COP measured against the S&P 500 Index (SPX). As the graph shows, COP is strongly outperforming the benchmark index, a good sign. Relative strength like the type COP is displaying in the midst of a weak broad market backdrop is a tip-off that the stock is in strong hands and should continue to outperform once strength returns to the rest of the market.
As is typically the case whenever there is strong internal weakness in the broad market, utility stocks are currently being treated by investors as a safe haven. The Dow Jones Utility Average (DJUA) shown below reflects the increased demand for the utilities in the last few days. Not surprisingly, the sharp rally in the DJUA occurred simultaneously with the huge increase in new 52-week lows on both exchanges. Rather than flee strictly to the safety of cash, investors have sought out safety in the conservative utility stocks.
It’s interesting to note that the rally in the DJUA began earlier this summer around the same time that the NYSE new 52-week lows began increasing with bond yield-related pressures. In view of this, the utility sector will likely remain a safe bet this month as long as the NYSE new 52-week lows remain well above 40 on a daily basis (which is the sign of an unhealthy market).
Meanwhile, the stock market’s immediate-term (1-4 week) technical picture showed a little more improvement on Tuesday. Although the S&P 500 Index is struggling to stay above its 50-day moving average, the 20-day price oscillator for the SPX finally fell into negative territory on Oct. 9. This marks the first time this has happened since early July, around the time when the market was bottoming from its last internal correction.
Normally, when the 20-day oscillator goes into negative territory, it denotes a market which is becoming “oversold” on a technical basis and often paves the way for a short-covering rally. The 20-day price oscillator for the SPX barely fell into negative territory on Tuesday (see below), but the further the oscillator declines in the coming days, the more likely we’ll have a confirmed market low in place by mid-October (which has been my expectation since last week).
With utilities and energy stocks maintaining a relative strength advantage over other sectors, investors at least have some safety-related options in the midst of the ongoing broad market weakness. Beyond conservative positions in the strongest performing stocks in these two leading sectors, however, I recommend that investors avoid making new commitments in stocks and ETFs in other sectors until the latest internal weakness has dissipated.
When the number of securities making new 52-week lows on both exchanges falls below 40 for several days, we’ll have confirmation that the market has finally returned to a position of health. For now, a defensive position is encouraged in the immediate term.
Investors can also maintain longer-term investment positions to the stock market via ETFs and outperforming individual stocks in strong sectors. This includes, in particular, the retail, healthcare, and tech sectors, which have all shown relative strength versus the S&P 500 Index in recent months.
With earnings growth still on a positive trajectory, the probability is strong that the large cap major averages will survive the latest increase in broad market volatility with their long-term uptrends remaining intact. I also recommend raising stop losses on existing long-term positions and taking profits in stocks and ETFs which have already had impressive upside moves.
Disclosure: I am/we are long XLK, XLV.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.