Know Your Sectors

11/08/2007 12:00 am EST

Focus:

Thomas Aspray

, Professional Trader & Analyst

Though sector analysis has been quite popular for many years, the disparity between various sectors in 2007 has made the argument for sector analysis even stronger. This does not mean that you must pay attention to each small movement in each sector, but knowledge of the major trends can help you avoid the underperforming sectors, which can have a dramatic impact on your performance

Figure 1

One of the simplest ways to monitor the sectors is to measure the performance of a sector against a major average such as the S&P 500, which is more broadly based than the Dow Industrials. This can be calculated in many ways, and there are several Web sites where you can do some basic relative strength (RS) analysis. This is not to be confused with the Relative Strength Index (RSI) developed by Welles Wilder. On the left side of the chart above, we have the RS on top in red and below it a chart of the Dow Jones Financial Index. The RS hit its high in September 2006, and when the sector made a new high in February of 2007, the RS made a slightly lower high. Prior to this, the series of higher highs indicated that the financial stocks were continuing to act stronger than the S&P 500. The shift in leadership in early 2007 was confirmed when the uptrend in the RS, line 1, was broken the week ending March 2, 2007. You will note on the chart that the sector declined for two more weeks but then rallied with the rest of the market and got very close to the previous highs in early June. On this rally, it is important to note that the financials were acting significantly weaker than the S&P 500 as the RS continued to decline.

The flip side of this is the Dow Jones Technology Index that shows a nice uptrend over the past few years. The first period I would like to concentrate on is the early part of 2007 when the RS line was flat during both the rally up to the February highs and the subsequent decline. So, how does one interpret this? It should be viewed as neutral since it indicates that the sector is keeping pace with the S&P 500, not stronger and not weaker. The RS improved on June 20, as the 18-month downtrend, line 2, was broken. This was the first indication that the technology sector might be starting to outperform the overall market. This was confirmed in mid-October when more important RS resistance, line 3, was also overcome. How much did they outperform? From the August lows until the first week in November, the Technology Index was up 17% while the S&P 500 was up just over 9%.

Figure 2

Of course, the weakness in the financial sector is partially a by-product of the collapsing housing market and sub-prime, etc.; however, the technical analysis warned of the weakness well before the housing problems became widely known. The S&P homebuilding sector bottomed in 2001, and by early 2002, was in a well-defined uptrend. For the next three years, both the bar chart and the RS line show a series of higher highs and higher lows (line 1). To further gauge the trend of the RS, I have added a 21-period EMA of the RS, as it is my view that a turn in a sector can first be identified by a violation of the EMA and it flattening out. If this is followed by a break of RS support, the slope of the EMA can confirm a top. The homebuilding stocks surged to a dramatic new high on July 22, 2005 as indicated by point 2. The drop from these highs was quite severe as the RS dropped below its EMA but held well above its uptrend. The sector rallied back towards the previous highs, but failed to make new highs (point 3) and again turned lower. The EMA had flattened out at this point and by the time the uptrend (line 1) was broken on March 10, 2006, the EMA was clearly declining. This is a pattern that I frequently see as a sector is topping out: often times the second peak will be lower than the first but sometimes, as was the case with the Financials (Figure 1), the highs are close enough to each other to call it a double top.

Figure 3

The S&P Real Estate group has also started to under-perform, but is still acting much better than the homebuilders. The real estate group is made up of both the real estate holding and development companies as well as the REITs. From the latter part of 2002 through mid-2004, the RS oscillated above and below its EMA and trend line resistance developed at line 1. This resistance was overcome on August 20, 2004 (point 2) as the downtrend was broken and the EMA was rising (line A). By the middle of 2005, an uptrend had developed in both the bar chart and the RS as they made higher highs. The sector spiked to the upside early in 2007, peaking on February 7 at 203.40. There is no secondary high on this chart, as after the first drop the sector moved sideways before another push to the downside which was enough to drop the RS well below both its EMA (line B) and its uptrend, line 3. The sector rebounded in September but seems to have peaked in early October as the RS just rallied back to its declining EMA. This is not a positive sign and suggests that at a minimum we will see a test if not a break of the August 2007 lows.

Figure 4

The railroad stocks have been doing well for the past three years but received particular attention in the spring of 2007 when Warren Buffet announced he had established significant positions in several of the railroad stocks. Now I seriously doubt that Warren is a “sector watcher,” and the current sector analysis indicates that the railroads may be reaching a critical juncture. On August 13, 2005, (line A) the railroad sector broke out above resistance (line 1), and the RS overcame its downtrend, line 2, and was already above its rising EMA. For the next two years, both the bar chart and the RS made higher highs and higher lows, but in the summer of 2006, the RS dropped significantly below its EMA. The RS did hold above its multi-year uptrend (line 3) and then resumed its uptrend. Though the sector made significant new highs in 2007, the RS has failed so far to make new highs (line 6). The uptrend in the RS was violated for two weeks in September 2007, and this, combined with failure of the RS to confirm the new highs, puts this sector in a vulnerable position. A drop in the RS below the September 2007 lows will signal that this group is likely to under-perform the S&P 500.

Figure 5

For the past five years, the mid-cap stocks, as represented by the S&P 400, have outperformed the large capitalization stocks that are represented by the S&P 500. The out-performance of the mid-caps over the large-cap stocks was very apparent in 2003, where the chart starts. As was the case in prior examples, both the sector and the RS continued to make higher highs for the next three years until May of 2006. On this decline in the overall market, the S&P 400 was weaker than the S&P 500 as the RS dropped below both its EMA and its uptrend, line 1. The S&P 400 resumed its uptrend in October 2006 as it rose another 15% above the previous peak, reaching the 168 level in the summer of 2007. On this rally, however, the RS failed to make new highs and the divergence between line 2 and line 3 could be an early warning signal. A break of RS support at line 4 would indicate that the mid-cap stocks have begun a period of weaker performance than the S&P 500. In order to indicate that the mid-caps will continue to outperform, the RS needs to move back above the resistance at line 3, thereby erasing the negative divergence.

There are many different ways of analyzing sectors but relative performance is one of the more easily understood methods. It is important to reinforce that the RS analysis does not give you any information on direction of the sector itself but just how it is performing versus another group or a market average. In a previous article, (link to Scanning the Sectors) I discussed some of the technical indicators that I use to analyze sectors and if you have not read it yet, you might find it beneficial.

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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