The 3 Most Vulnerable Sectors

09/22/2011 10:45 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

These major market sectors are still looking very vulnerable and are likely to continue to underperform the S&P in the months ahead. Use careful risk controls to avoid big losing positions.

The late-in-session drop in the stock market after the Fed announcement was consistent with the deterioration in the technical outlook discussed yesterday. The McClellan Oscillator has broken below support, which makes a further drop very likely.

Three of the major sectors look most vulnerable to further selling and they are likely to underperform the S&P 500. Even though technology was also lower, it continues to show better relative performance, or RS analysis, which suggests the tech sector will hold above the August lows.

For the Select Sector SPDR - Energy (XLE), it is important to keep an eye on crude oil prices. As I have frequently pointed out, crude oil often leads the stock market on both the up and down side. November crude oil was down over $2 yesterday, and a break of key support would be a negative for the energy sector and stocks in general.

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Chart Analysis: November crude oil completed its flag formation, lines a and b, on Monday, but so far, the short-term lows in the $84.65-$84.90 area are holding. The key chart support is now at $83.47.

  • There is further support at $79.76 and then at $76.61. The 127.2% Fibonacci retracement target is at $72.53
  • The on-balance volume (OBV) broke its uptrend, line c, on September 9 before rebounding sharply
  • Volume has been heavy over the past three days and the OBV now shows a pattern of lower highs and lower lows
  • Crude oil has resistance at $88 with stronger resistance in the $89-$90.63 area

The weekly chart of the Select Sector SPDR - Energy (XLE) shows that it is not far above the weekly uptrend (line d) and the 50% retracement support in the $59-$59.40 area. XLE completed a daily head-and-shoulders top formation in May.

  • The major 61.8% Fibonacci support stands at $54.50
  • The relative performance, or RS analysis, turned positive in October 2010, signaling that XLE was going to be stronger than the S&P 500. The RS analysis topped in May and is negative, as it is still below its declining weighted moving average (WMA)
  • The weekly OBV formed a negative divergence, line f, at the late-April highs. The OBV needs to break this downtrend to turn positive. The OBV is below its weighted moving average
  • There is initial resistance for XLE at $67.76-$69.90

NEXT: 2 More Key Sectors Likely to Move Lower

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The Select Sector SPDR - Industrial (XLI) has been one of the weakest sector ETFs, down 24.6% from the April high at $38.98. The daily chart shows a completed head-and-shoulders top formation, as the neckline (line a) was broken in July.

  • The daily chart shows next support at the uptrend (line b) in the $29.50 area
  • Major 50% retracement support stands at $27.40 with the downside target from the daily chart formation at $26.40
  • The daily uptrend in the RS (line c) was broken in May and still looks negative
  • Daily OBV confirmed the completion of the top formation when it dropped through long-term support at line d
  • Weekly OBV formed a negative divergence at the May highs and is still negative
  • There is initial resistance for XLE at $32.20 and then at $32.89

The Select Sector SPDR - Materials (XLB) closed below short-term support, line g, on Wednesday. This suggests it will continue to lead the market lower. The daily chart shows a completed top formation, lines e and f.

  • Major 50% retracement support is at $29.70
  • The daily chart formation has downside targets in the $28.50 area
  • The daily uptrend in the RS, line h, that goes back to the 2010 lows, was broken in early May. The RS is now dropping very sharply and XLB is acting weaker than the S&P 500
  • The OBV is in a solid downtrend, line i, though we may have seen a selling climax in early August

What It Means: These three key sectors have been the weakest over the past four months. The weakness in crude oil suggests it is ready for one more decline, but the longer-term technical analysis for crude oil suggests that this could complete a bottom formation. Therefore, the energy sector may bottom out first.

The industrials and materials sectors gave weekly sell signals in May (see “2 Key Sectors Top Out”). Both now look ready to lead the markets lower, and a resurgence of growth in the emerging markets is likely necessary before these sectors turn around.

How to Profit: I see no real profit opportunities at this time, but those holding stocks in these sectors should be sure to use stops on all positions to limit the risk. It is tough to come back from a 30%-40% hit in one position.

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