How much upside potential is there for stocks and funds in the relief rally that’s now underway? That’s the question investors are asking, and while there is no absolute answer, it’s always helpful to examine the leading sectors and industries for signs of above-average strength. While we may not be able to predict the duration or magnitude of the current rally, by focusing mainly on the market groups which sport the most relative strength, investors can potentially increase their profits during the market’s recovery phases. Today we’ll look at some of those promising market segments.
The stock market’s internal condition has shown dramatic improvement in the last few days, and an immediate-term low has been confirmed for most sectors. This set of conditions means it’s time to take a look at some industry groups that have above-average rally potential. By way of caveat, I would caution that there’s no guarantee the industries I’ll mention here will live up to my positive expectations and may have only a temporary relief rally. However, with internal selling pressure drying up for the first time in four months, the odds are finally starting to stack up in the bulls’ favor.
Fortunately, there are no shortage of beaten-down and undervalued stocks out there to choose from and this makes it easier to select equities with turnaround potential. Let’s start with the industries which posted a bottom well before the major indices did. While the benchmark S&P 500 Index (SPX) hit a pivotal low in late December, there are a handful of industry groups which bottomed as early as October without violating those lows during the December decline. One of the more prominent examples of the early bottoming industries is found among the home builders.
Shown below is the Dow Jones U.S. Home Construction Index (DJUSHB), which established a low in late October and then successfully tested that low in late December. The Dow Home Construction Index has since confirmed the October low by making a series of higher peaks and higher lows, even as the SPX was making lower lows. The Dow Home Construction Index suffered a fierce decline from January 2018 until October and the leading home construction stocks are in much better shape technically and fundamentally compared to a year ago. Accordingly, I anticipate a decent recovery for the home building stocks in the coming weeks.
Another industry which has above-average rally potential is the railroads. Shown below is the Dow Jones U.S. Railroads Index (DJUSRR) compared with the S&P 500. As you can see, the railroads have clearly outperformed the broad market of late, including an impressive 5.43% upside pop on Jan. 8. U.S. railroads are a strong performing industry right now based on the data. According to the Association of American Railroads, rail traffic for December showed a 4 percent increase from the year-ago period. Total combined U.S. rail traffic for the year 2018 was also 3.7 percent higher compared to 2017, according to AAR. The relative strength reflected in the stock prices of U.S.-listed railroad companies is a testament to the continued strength of the U.S. economy. Incidentally, this is another reason for believing the U.S. will dodge a recession in the coming months.
Even more impressive than the railroads is the recent performance of restaurant stocks. The following graph features the Dow Jones U.S. Restaurants & Bars Index (DJUSRU) along with the SPX. Right now food and beverage providers are hands-down the strongest performers among the major Dow Jones industry groups. DJUSRU is also one of the few industry-specific indices which is showing a degree of forward momentum. This gives restaurant stocks a decided advantage in terms of upside potential should the latest broad market rally gain traction in the coming weeks.
For much of last year, one of the biggest disappointments was the gold miners. Gold stocks took a big hit in the first eight months of 2018 despite promising industry fundamentals. Yet despite the stock price plunge in the leading mining and exploration companies last year, the overall industry has shown remarkable improvement in the last four months. Below is the Dow Jones U.S. Gold Mining Index (DJUSPM). As you can see, the gold mining index is about to surpass the S&P 500 in terms of relative performance and is showing decisive strength after having established a series of higher highs and lows since September. Investors should consider having a conservative position in some gold stocks during the broad market recovery phase.
A final industry group which deserves mention is the pharmaceuticals. The Dow Jones U.S. Pharmaceutical Index (DJUSPR) is also in a relative strength position versus the S&P 500 Index. Pharma stocks were among last year’s top performers before the fourth quarter market correction, and based on the technical position and fundamental condition of many leading drug stocks, the odds favor a meaningful comeback in this industry group in the coming months.
As we’ve discussed in recent reports, the selling pressure which characterized the stock market for almost the entirety of the October-December period has significantly diminished. On Tuesday, for instance, the NYSE 52-week new highs-lows differential was positive for the first time since October. The daily improvement in the new highs and lows since last week confirms that the incremental demand for equities is finally starting to increase. Assuming this improvement continues in the coming days, the worthwhile rally I anticipated for the coming weeks should afford an excellent opportunity for investors to do some buying in the most attractively valued stocks of the industry groups reviewed above. I’ll have more to say about these industries in upcoming reports. For now, investors should be looking to (cautiously) deploy some capital in the aforementioned industries.
Disclosure: I am/we are long IAU. 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.