The Laggards Are Becoming Leaders

Includes: ITB, IYR, SMH, SPHQ
by: Clif Droke

In another sign of recovery, key industries are getting stronger.

Among them are real estate, transportation, and semiconductors.

Growth stocks also say the bear is at bay and bull holds sway.

Some of the most economically sensitive and important market industry groups are finally showing signs of strength - and even leadership - after lagging the S&P 500 Index (SPX) last year. Among the late-comers to the recovery party are the critical homebuilders, the transports, and the semiconductors, all of which we’ll review in today’s report.

After last week’s stumble, the stock market has proven that its bias is to the upside in the last few trading sessions. The bears’ collective argument was largely predicated on a significant decline following last week’s pullback. Many bearish commentators also believed that a V-shaped recovery in the major indices was a virtual impossibility at this point. Yet a V-shaped reversal is essentially what has transpired over the last few weeks, and the series of higher highs and higher lows in the major averages confirm that the recovery is alive and kicking.

One sign which shows just how much strength the market has is the strength in the growth stocks. In a broad-based rally, it’s always important that growth stocks participate and, if possible, lead the major averages higher. That growth stocks are strongly participating in this recovery can be seen in the following graph which shows the progression of the Russell 1000 Growth Index (RLG). The growth stocks as represented by RLG have recovered all their losses since November and are well on their way to regaining October’s losses. I consider RLG to be one of the most important confirming indicators of the broad market’s strength or weakness, and with the index above its rising 15-day and 50-day moving averages, the dominant short-term and intermediate-term trends can be considered up.

Russell 1000 Growth Index

Source: BigCharts

The strength and recovery visible in the growth stocks is symptomatic of what’s happening across a swath of industries right now. Many of the stocks in these industries can be considered to be in the growth category. More importantly, though, is that three of the industry groups which have returned to a position of strength after months of lagging the S&P are economically sensitive and therefore have a measure of forecasting significance for the U.S. economy and intermediate-term (3-9 month) stock market outlook. Let’s take a look at them.

One of the most encouraging performances of the year to date is the rebound in the homebuilder stocks. After a steady downward slide in the first half of 2018, culminating with a brutal sell-off in September and October, the leading homebuilding companies have now recovered most of their losses since October. The iShares U.S. Home Construction ETF (ITB) is a popular benchmark for this industry, and the following chart shows steady recovery in the homebuilders since the late December bottom.

iShares U.S. Home Construction ETF

Source: BigCharts

The recovery in the homebuilders and other real estate equities is more than just a “dead cat bounce,” however. According to FactSet, real estate is one of the three sectors reporting double-digit revenue growth in the latest quarter. The stock price recovery among homebuilding and REIT stocks is as much fundamentally based as it is technically based. The sharp drop in U.S. Treasury yields (see 10-Year Yield Index below), and subsequent reversal of the Fed’s rate-hiking bias, has also served to contribute to the recovery in this sector.

CBOE 10-Year Treasury Note Yield Index

Source: BigCharts

Another example of how real estate equities in general have quickly gone from a position of weakness to one of strength is seen here. The following graph shows the iShares U.S. Real Estate ETF (IYR), which has recently made a new 52-week high and is currently one of the strongest performing sector ETFs. This suggests that real estate investors aren’t worried about the interest rate outlook, as they were for much of last year. It also reflects well on the economic outlook for the coming months as problems in the economy normally show up first in the real estate sector before they do in other areas.

iShares U.S. Real Estate ETF

Source: BigCharts

Next let’s turn our attention to the critically important transportation industry. As the venerable Dow Theory teaches, a bull market in stocks can hardly be considered healthy without widespread participation among the various segments of the transportation group. The financial health of the airlines, railroads, and freight transporters are indicators of the strength or weakness of the U.S. commercial system.

Without the constant flow of goods, commerce would quickly grind to a halt. Thus, the transportation stocks can be considered as confirming (and sometimes leading) indicators of the stock market’s intermediate-term health, as well as the strength of the economy itself.

With that said, here’s what the Dow Jones Transportation Average (DJTA) looks like as of Feb. 12. After the lagging the benchmark SPX in the latter part of 2018, the DJTA has since launched an impressive recovery and is on the verge of catching up with the SPX. The Dow Transports have also established a recurring series of higher highs and lows since the December bottom and have remained above the 15-day moving average since then. While the Transports haven’t yet achieved to a leadership position, they’ve nonetheless recovered and are confirming that the bulls have control over the dominant interim trend.

Dow Jones Transportation Average

Source: BigCharts

While there are other industries we could discuss which fall under the category of turnarounds, suffice it for this report that the most important of them is the semiconductor stocks. The semiconductors are tech bellwethers and also tend to send leading signals for the NYSE broad market. For instance, the semiconductors were among the first of the big industries to show signs of weakness ahead of last summer’s top in the major averages. Since December, however, the semis have confirmed the rally in the SPX and have finally caught up with the benchmark index. This is shown in the graph of the VanEck Vectors Semiconductor ETF (SMH), below.

VanEck Vectors Semiconductor ETF

Source: BigCharts

With three of the most economically sensitive industries showing signs of being in full-fledged recovery mode, investors can finally exhale and stop worrying about the bear’s return. With real estate, transportation and semiconductor stocks all in sync to the upside, the likelihood of a bear market occurring anytime soon are extremely slim. As long as these groups are at least keeping pace with the recovery in the SPX, investors are justified in embracing a bullish bias.

On a strategic note, investors should be long the sectors and industries which are showing the most relative strength and solid fundamentals. In particular, investors should be looking at consumer staples, pharmaceuticals, and real estate equities, as well as the tech sector in general. I also recommended last week that technical traders take some partial profit in market-tracking ETFs, such as the Invesco S&P 500 Quality ETF (SPHQ), of which I’m currently long. After the impressive upside run of the last few weeks, now would be a good time to book a little profit and raise stop losses on long positions in the event my bullish thesis is wrong and selling pressure increases.

Disclosure: I am/we are long SPHQ, IAU, XLE. 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.