Sector Timing - Entries & Exits

12/06/2007 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

In an earlier article, we discussed how to use comparative relative strength to select the sectors or industries that should outperform the overall market (Know Your Sectors). To review, by plotting the ratio of sector price to that of a major average such as the S&P 500, you can observe shifts in leadership that would allow you to purchase stocks or ETFs in the strongest sectors or industries. But this is only one part of the equation, as determining an entry point where the risk is reasonable or a good place to take at least partial profits is also a challenge. Have you ever had a stock position in a sector that is outperforming the major averages by a wide margin, only to have it reverse, leaving you in a quandary as to what you should do? If you have not yet encountered this situation, it is almost inevitable that you will at some point. These kinds of situations put the investor or trader in the position of riding out a 5-10% correction, or, even worse, panicking and selling outright near the correction lows. In this article, I would like to demonstrate a few methods or tools that might serve to improve your exits and, although to a lesser degree, your entries.

Table 1

The table above shows the ten major sectors and the S&P 500 Index with their performance through 9-28-07, and the table reveals a wide disparity in the returns for the various sectors. If you were in the S&P for the 12 months ending 9-28-07 it was up 4.6%, compared with 40.9% for the energy sector or 0.9% for the financials. Some of the disparities in the three- and six-month performance numbers further reinforce the necessity of being in the right sector.

In addition to the comparative relative strength (RS), I have also added a short-term momentum indicator called RSI3, and on the weekly chart of the S&P energy sector. I have also added the STARC bands. Both the RSI3 and STARC bands were discussed in previous articles, but here is a brief review. The RSI3 is a three-period simple moving average of a five-period RSI, which can be helpful in identifying short-term turning points. The STARC bands, developed by my good friend Manning Stoller, plot two standard deviations of a 15-period average true range (ATR) above and below a six-period simple moving average of the price. When prices are near the upper bands it is a high-risk time to buy, and a low-risk time to sell; conversely, if they are near the lower band then it is a high-risk time to sell and a low-risk time to buy. Risk here is just relative risk, as when prices are near the bands they are close to an extreme, and the majority of the time prices will either move sideways or reverse direction over the next several bars.

Figure 1

As I noted in the introduction since we are using the RS for selecting a sector or industry, the combination of the RSI3 and STARC bands, in my experience, seems to do an especially good job of identifying an exit point. Basically, once you decide that you are looking to establish a long position in a sector because the RS has broken out to the upside and is above its WMA, you then look to go long at a price that is between the lower band and the MA (blue line). Also, ideally, the RSI3 will have turned up from below 40. Conversely, on the sell side, momentum and risk are the main concerns since you are looking for a point to reduce your exposure and take some profits off the board. Using the energy sector as an example, the price consolidated from late 2006 to March 2007, and as line A indicates, it was a bit weaker than the S&P 500. On March 24, 2007, the RS moved through its downtrend after already surpassing its WMA, and the RSI3 on the top part of the chart had just turned up from the 40 level. The sector closed well above the lower STARC band, but with a stop under the lows from three weeks earlier, the risk could have been well-controlled.

The RSI3 moved above the 90 level in early June (point 1), but then after a two-week setback, the sector made significant new highs. During the week ending July 20th, 2007, the RSI3 formed a negative divergence above 80 (point 2). It closed the week within 3% of the upper STARC band. After a four-week correction, the sector was down approximately 12% from the highs and had reached the lower STARC band while the RS was still holding above its WMA. Of course, since we are looking at 2007, this focuses on the correction fueled by the sub-prime crisis, which was hardly typical. Therefore, I think it would be helpful to take a look at another historical period where the price action was more normal.

Figure 2

In the second example we are looking at the energy sector from May 2005 through July 2006. This sector rose over 30% from the May lows until late September as the energy sector came very close to its upper STARC band (line A); additionally, two consecutive RSI3 readings above 77 were also a reason for concern. The sector then underwent a sharp 10% decline back to the lower STARC bands, and dropped the RSI3 well below the 40 level. Less than four months later, in the latter part of January 2006, the upper STARC band was again being tested and the RSI3 was at 80; however, this time the correction was not as severe. In April, the sector closed less than 1% below the upper STARC band, but the RSI3 was at 74 and thus not as overbought. It is critical to understand that the RSI3 and STARC bands identified the peaks and valleys so accurately in this instance primarily because the sector was in such a well-established, long-term uptrend.

Figure 3

One of the weakest sectors over the past 12 months has been the consumer discretionary, as it has been weaker than the S&P 500 for both the three- and six-month periods leading up to September 28, 2007. There were, however, periods where the performance was better, as the downtrend in the RS was broken on September 16th, 2006 (line A), as the RS had moved above its WMA a few weeks earlier. However, at this point; the RSI3 was around 50, and the close was very near the upper STARC bands. As the chart indicates, the sector rode the upper STARC band for much of the next five months, as the RSI3 peaked at 85 in late October. By early 2007, the RSI3 had formed a three-month negative divergence (line b), suggesting a more cautious position was warranted. Then, in March 2007, the RS dropped below its WMA, signaling it was likely to be weaker than the S&P 500. This trend has continued for the rest of the year.

Figure 4

Of course, once you identify the strongest sectors, your leverage will be increased by narrowing your focus to the strongest industries within that sector and then again by looking at the best performing stocks within those industries. While the discretionary consumer sector has done poorly this year, one industry in this group, the S&P Internet & Catalog sector, has done very well, up over 60% in the 12 months ending on September 28, 2007. On the chart you will note that an 18-month downtrend on the price chart (line a) was broken in September 2006 (line A). This was supported by the breaking of the downtrend in the RS (line b). At this point, however, the upper STARC band was already being tested, and the RSI3 was at 69 and rising sharply. Three weeks later, the upper STARC band was again tested and the RSI3 was above 80. Over the next four months, a sideways trading range developed. By early March (line B), prices had dropped below the six-period SMA and the RSI3 had reached the 40 level. This preceded a 50% rally for the industry over the next three months, with some stocks (such as Amazon) doing even better. By mid-June, the RSI3 had formed a double-top well above 80 (see red circle) and the upper STARC band was being tested. Therefore, risk was high on the long side, and the probabilities favored taking at least some partial profits.

If you are not familiar with the STARC bands or the RSI3, I would encourage you to read one of my earlier articles on them, as I do think they can be effectively combined, especially to help refine one’s exit points or to identify a time and price when partial profits might be taken. In the next article, I will see if we can combine the readings from both indicators into a single risk-gauge that might be helpful in our sector analysis.

As always I welcome your feedback on these articles. I can be contacted at tomaspray@intershow.com. I would also appreciate any suggestions you may have for future articles.

Tom Aspray, professional trader and analyst, serves as video content editor for InterShow's moneyshow.com video network. Mr. Aspray joined InterShow full time in June of 2007 where he also does other editorial work for the site, including the bi-weekly trading lessons and the weekly charts to watch. Mr. Aspray has written widely on technical analysis and has given over 60 presentations around the world. Over the years, he has applied his methodologies not only to the stock and commodity markets but also the global markets, mutual funds, and foreign exchange. Many of the technical indicators that Mr. Aspray wrote about in the 1980s, such as the MACD, have since gained worldwide acceptance. He was originally trained as a biochemist but began using his computer expertise to analyze the financial markets in the early 80s. As a consultant, Mr. Aspray wrote daily institutional reports for firms such as Fleming Jardine and Barings Bank and was noted by the Wall Street Journal as one of the "top bond market technicians."

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