Seeking Alpha

3 Industries That Will Lead The Next Rally

by: Clif Droke

Consumer staples, food retailers and brokers have relative strength.

Expect these three stock segments to outperform in the next rally.

Odds favor a September turnaround in the major U.S. averages.

After being in control last month, the bears are under assault from buyers who are determined to regain control of the stock market’s immediate-term trend. And while the struggle is still undecided, there are some conspicuous areas of strength in an otherwise volatile broad market. Demand has been especially strong in the food and beverage industry, as well as consumer staples. There is also evidence of re-emerging strength in the broker/dealers. We’ll examine each area in today’s report as I make the case that once a bottom has been confirmed, these three industries will lead the market higher into the fourth quarter.

Equities were up in the closing days of August in response to the more benevolent tone of the U.S.-Sino trade war. China officials have expressed interest in resuming "calm" negotiations with the U.S. on trade tariffs in recent days, which has given Wall Street some much-needed optimism. With trade war fears being the primary reason behind August’s volatility spike, it makes sense that any good news on the trade front will also remove the main impediment for higher stock prices. Nevertheless, the market remains quite vulnerable to news right now – both good and bad – and while the bulls are finally in a position to decisively take control of stocks this week, it’s still too early to start buying with both hands just yet.

The market is extremely close to confirm an immediate-term (1-4 week) breakout signal based on my trend indicator. Of the six major indices which comprise this indicator, the Dow 30, S&P 500 (SPX), S&P 400 Midcap Index (MID), and NYSE Composite (NYA) have all closed two days higher above the 15-day moving average as of the last day of August. Assuming this signal isn’t reversed when trading resumes on Sept. 3, we’ll have a confirmed breakout signal this week. The other two components of the trend indicator – the Nasdaq 100 (NDX) and Russell 2000 Smallcap Index (RUT) – haven’t yet closed the required two days above the 15-day MA. Only four of the six trend indicator components (i.e. a simple majority) are needed to confirm a breakout signal, however.

There has also been a shrinkage in the number of stocks making new 52-week lows on both exchanges, most notably on the NYSE. There were only 46 new lows on Aug. 29 and just 39 on Aug. 30. Assuming we see another couple of days where fewer than 40 NYSE-listed stocks make new 52-week lows, to accompany the 2-day close above the 15-day moving average, it will provide an additional confirmation that internal selling pressure has diminished enough to allow the bulls to regain control of the immediate-term trend.

The only thing that bothers me about the recent performance in the new highs and lows is the fact that the 4-week rate of change (momentum) in the 52-week highs and lows fell dramatically until just a couple of days ago. When the major indices are near all-time highs and the 4-week high-low momentum indicator is dropping precipitously like it has, it nearly always results in a soft stock market. For most of the past month, the number of energy sector stocks crowding the new 52-week lows list has been alarmingly high. Unless we see a sustained shrinkage in the number of the energy stocks making new lows in early September, the market’s short-term internal momentum shown below could still be a negative factor going forward.

Source: BarChart

If the major indices continue to rally from here, however, this will be one of those rare instances when stocks simply refused to buckle under the pressure of sustained weakness in other major sectors. I’m not sure how to explain this other than the fact that fear has been running so high lately, causing short interest to build up substantially. Also, with investors scared out of their wits over the trade war, there’s a very good chance the market has already discounted the worst possible outcome for corporate earnings. And if that’s the case then stocks really have nowhere to go but up once those fears are finally alleviated by a temporary truce between the U.S. and China.

Although the energy stocks have posed the biggest threat for the rest of the market in terms of spillover weakness, a confirmed bottom signal in the NYSE Arca Oil Index (XOI) in the coming days would also go a long way toward alleviating one of the market’s biggest concerns. It would also relieve a substantial amount of the internal selling pressure which has plagued the NYSE for several weeks. A decisive 2-day higher close above the 15-day moving average in XOI this week would also likely facilitate another short-covering relief rally for the major indices. This in turn would make it even easier for the bulls to consolidate their control over the near-term trend.

NYSE Arca Oil Index Source: BigCharts

Another important area that traders should be watching in the coming days is the extremely sensitive broker/dealer stock group. A confirmed bottom in the NYSE Securities Broker/Dealer Index (XBD) looks all but assured this week (below), and it’s always considered a positive when the broker/dealers lead or confirm the major averages like the S&P 500. After all, what’s good for broker/dealer stocks is unquestionably good for the rest of the market.

NYSE Securities Broker/Dealer Index Source: BigCharts

Among the notable winners last week was Campbell Soup Co. (CPB). The company beat earnings expectations, resulting in a 4% rally for its stock price to end the month of August. Campbell's stock performance is a salient consideration right now since it trades in the food and beverage retail industry. This group, along with consumer staples, is one of the top-performing market segments right now. Food retailers sport one of the most positive price share outlooks from a fundamental, relative strength (versus SPX), and price momentum perspective. The relative strength factor is an important one, for stocks and industries which outperform the SPX during a market decline are typically in strong hands. This in turn increases the chances that the stocks in question will continue outperforming once the rest of the market firms up. Accordingly, after my immediate-term trend indicator gives a buy signal, I plan on making some purchases within this industry.

As an example of the stellar relative strength and outperformance of this market group, note the following graph of the Invesco Dynamic Food & Beverage ETF (PBJ). This ETF will likely be one of the leaders during the bull market’s next rally phase once we get an “all clear” signal that the recent broad market internal selling pressure has completely diminished.

Invesco Dynamic Food & Beverage ETF Source: BigCharts

Consumer staples stocks are also on the short list of sectors and industries which have notably outperformed the S&P 500 Index in the past month. While staples stocks are regarded as defensive in nature, in the present environment I expect them to continue outperforming the SPX even after the latest bout of volatility has completely subsided. Investors are clearly in a defensive posture this year and that’s not likely to change anytime soon. For that reason, I expect the Consumer Staples Sector SPDR ETF (XLP) to maintain its intermediate-term bull market into year’s end.

Consumer Staples Sector SPDR ETF Source: BigCharts

Another area which will be important to monitor in coming days for signs of improvement is of course broad market volatility. Specifically, the CBOE Volatility Index (VIX) should ideally fall decisively below the 16.00 level to let us know that volatility is on the wane. As I’ve emphasized in recent reports, with the VIX closer to the 20.00 level or above, it rarely pays to buy stocks due to the increased risk of news-related choppiness that an elevated VIX level implies. By contrast, between the 10.00 and 15.00 levels is where the VIX should ideally be fluctuating in a broad market rally. A VIX between these levels is far more conducive for buying stocks in a bull market like this one.

CBOE Volatility Index Source: BigCharts

September has the potential to be the month when broad market volatility subsides and trade war fears are put at least temporarily on the backburner. When that happens, expect the broker/dealer, consumer staples, and food and beverage stock groups to lead the way higher in the next broad market rally. Each of these three groups is attractively valued and has strong upside potential based upon relative strength considerations. Because the demand for these stocks has been so high at a time when other industries were weak, the implication is that they were bought by informed investors who foresee their continued strength. Participants should accordingly turn their attention to these three groups while awaiting a confirmed broad market bottom signal.

Disclosure: I am/we are long GDX. 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.