Investors Should Focus On Relative Strength

Includes: COF, PUI, SPHQ, VNQ, XLP
by: Clif Droke

After a market pullback, it's important to look for instances of strength.

The industries immune to the decline will likely be the next leaders.

Consumer staples, utilities, and real estate stocks fit this category.

One of the most invaluable studies an investor can undertake after the stock market has declined is to look for signs of relative strength among the major industry groups. By comparing the performance of several sector- and industry-specific averages to the benchmark S&P 500 Index (SPX), an idea as to which industries will likely lead the next rally can be obtained. In today's report, we'll cover some of the industries which have shown conspicuous signs of relative strength in the wake of the latest broad market pullback, including utilities, real estate equities, and consumer staples.

The stock market got a boost from improved sentiment over the U.S.-China tariff dispute in the last two trading sessions. Several high-profile headlines in the financial press gave participants a reason to be hopeful that the bad news has been largely discounted by the stock market. Economists at Citi, for instance, were reportedly optimistic that a trade deal will be eventually made between both countries. President Trump also tweeted on Tuesday, "We can make a deal with China tomorrow, before their companies start leaving so as not to lose USA business," which many were inclined to interpret as a sign that Washington remains open to expeditiously resolving the trade dispute.

Despite the rally in the major averages in the last two sessions, however, the market remains somewhat vulnerable to some additional spillover pressure. This is reflected in the downward path of the 4-week rate of change in the 52-week highs and lows, shown below. This indicator is my favorite way to measure the market's near-term path of least resistance, and right now, that path is still decidedly downward. We need to see this indicator reverse its decline before we get the next confirmed bottom signal.

Source: WSJ

The stock market's biggest obstacle in the immediate term is the above-normal number of stocks on both major exchanges, which are still making new 52-week lows. On the Big Board, for instance, the new lows are mostly comprised of a mixture of drug, biotech, and energy companies, but even a few retailers and bank stocks have lately made the list. There were 63 new lows on the NYSE on Wednesday, and 69 new Nasdaq lows. We should ideally see fewer than 40 new lows on both exchanges for a few consecutive days, which would tell us that all remaining signs of internal weakness have dried up.

Another thing that should happen before we get the next confirmed buy signal is for the stock market to return to a decisively "oversold" technical condition as reflected in my Composite Gauge indicator. The Composite Gauge is used to determine whether the market is thoroughly oversold from a technical as well as a psychological basis. It also indicates whether "smart" traders have begun buying stocks after a decline.

The Composite Gauge is comprised of four major inputs: the OEX put/call ratio, the AAII bull/bear differential, the insider buying/selling ratio, and the SPX 20-day price oscillator. It has nearly always fallen into negative territory below the zero level when a market bottom has been firmly established. As of May 14, the Gauge reading was only +32. There is still room for some additional downside in this indicator before the large-cap stock market becomes completely sold out and, therefore, vulnerable to a major short-covering rally. We're almost there, but not quite yet.

Source: CBOE

I mentioned previously that one of the things investors should look for after a market pullback is signs of relative price strength - and weakness - among the major industry groups. Specifically, it's imperative to look for how the major industries are performing compared with the S&P 500 Index. When an industry group or sector is showing conspicuous strength compared with the S&P 500, that's a good sign that the industry in question will likely outperform the SPX during the next broad market rally. Conversely, when an industry is conspicuously lagging the SPX, that group of stocks will likely underperform in the next rally.

One of the most important major industries in terms of its implication on the overall health of the broad market is the banks. Bank stocks have been one of the laggards of for several months and, despite threatening to breakout higher in April, have failed to keep pace with the benchmark S&P 500 Index (below). When we finally have confirmation that the next broad market rally has begun, it would be comforting to see the PHLX/KBW Bank Index rally in line with the SPX and push above its nearest high from earlier this month. This would tell us that the stock market is in the best of health since widespread participation by the bank stocks has always accompanied the strongest bull markets.

PHLX/KBW Bank Index

Source: BigCharts

I would hasten to point out, however, that most major U.S.-listed bank stocks are in good shape from a fundamental perspective. Most have low P/E ratios and decent dividend yields. Most show impressive growth in terms of 12-month trailing revenues and earnings. A handful of major U.S.-listed bank stocks, for example, Capital One Financial (COF), even sport a price/earnings-to-growth ratio (PEG) of less than 1.0, which is ideal. However, my latest review of the 50 most actively traded bank stock price graphs tells me that many banks are closer to year-to-date lows than highs. This means the bank stocks remain vulnerable to further weakness until the stock market has confirmed a short-term bottom. To repeat, a bottom will be confirmed once the new 52-week lows on both exchanges shrink below 40 for a few consecutive days.

Now, let's switch gears and take a look at some industries which are actually showing clear signs of relative strength. As you might expect, given the current climate of fear, safe-haven assets are outperforming most sectors and industries. Gold has been rallying of late, along with the Japanese yen, the Swiss franc, and U.S. Treasury prices. Among the traditional havens, however, one of the best performers has been the utilities. Shown here is the Invesco DWA Utilities Momentum ETF (PUI), which can certainly benefit from residual trade war-related fears in the near term.

Invesco DWA Utilities Momentum ETF

Source: BigCharts

However, there is also a tendency for the strongest performing stocks during a broad decline to continue performing strongly once the broad market turns up again. The reason for this tendency is that when a particular industry shows strength during a market decline, it's likely due to the influence of informed buying. Small retail investors, after all, are more inclined to sell stocks during a "panic attack" like the one we saw recently. But the "smart money" crowd always looks for bargains when the market is in decline. Thus, relative price strength within a given industry or individual stock, while the major averages are dropping, implies that those in the know see something worthwhile in the industry in question.

Another area which has thus far been immune from the panic selling is real estate, which, in recent years, has been a safe haven of sorts. After the Dow and S&P have plunged, and I'm waiting for the next confirmed bottom signal from my indicators, one of the first things I look for is signs of relative strength in the major sectors and industry groups. If the relative strength in the real estate equities continues a few more days, we'll have a renewed buy signal for this group. Shown here is the Vanguard Real Estate ETF (VNQ), which reflects the relative strength of real estate stocks in the aggregate compared to the S&P 500 Index.

Vanguard Real Estate ETF

Source: BigCharts

Yet another prominent example of relative strength right now is in the consumer staples sector. As with the utilities and the real estate stocks, consumer staple stocks are widely regarded as a defensive investment, which is where most of the money has flowed in 2019. Shown below is the Consumer Staples Select SPDR ETF (XLP), which is my favorite proxy for this group. XLP has held up well to Wall Street's recent fear-induced selling wave and has been one of the top-performing sector ETFs this year. Based strictly on momentum and relative strength considerations, the consumer staples should continue providing investors with good returns in the months ahead.

Consumer Staples Select SPDR ETF

Source: BigCharts

In view of the three major areas of relative strength discussed here, investors are justified in maintaining long positions in these industries. However, I suggest waiting until the new 52-week lows on both the NYSE and the Nasdaq shrink to normal levels mentioned above before initiating new long positions. My expectation is for the stock market's rising trend to be resumed by the end of this month as investors come to realize that stocks remain in strong hands and that today's headline fears won't kill the bull. Investors are still justified in maintaining a bullish intermediate-to-longer-term outlook on equities.

On a strategic note, my trading position in my favorite market-tracking ETF, the Invesco S&P 500 Quality ETF (SPHQ), was stopped out on May 13 after the ETF fell under the $31.70 level on an intraday basis, triggering my stop loss. This puts me back in a cash position in my short-term trading portfolio. Meanwhile, investors can maintain longer-term positions in fundamentally-sound stocks in the top-performing consumer staples, real estate and utilities sectors as we wait for the latest short-term market weakness to dissipate.

Disclosure: I am/we are long XLF. 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.