Scanning the Sectors

08/16/2007 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Since I am on vacation this week and given the market's recent gyrations, I thought it might be beneficial to revisit an article that I wrote about a year ago on scanning the sectors. Often after the market reverses direction, the leadership will also change and the methods discussed in this article might assist you in identifying the next leading sectors.

In a recent article, I discussed how the Average Directional Movement Index (ADX), developed by Welles Wilder, could be used to separate trending from non-trending markets. If you have not read this article, it might be helpful in better understanding the process I will be discussing this week. (link to Trading Basics--Trending or Not? Part 1)

In August 2005, I gave a presentation at the Trader’s Expo titled Technical Selection of the Best Sectors and Stocks. As I promised to my attendees, I will now review the results of the analysis. But first, I will give you a brief review of the methods that were discussed during this presentation. The overall premise of the presentation was how finding the strongest sector from a technical standpoint would allow you to look within that sector for the strongest stocks. This process, it is believed, can dramatically improve your chances of investment success. This is not a new idea, and the purpose of the presentation was to show how you could develop a simple scanning process, using Metastock, to identify the best sectors. At the time, the housing sector was strong and had been for over two years. Though the homebuilding index was up over 200% at the time, the gains in the individual stocks were even greater.

Before we go through the details of the scanning process, it should be noted that this is just one example of how to isolate the strong sectors. Also, I’d like to state that while I believe this method will select the strong sectors, I offer no guarantees of success using this approach. Some traders have better luck with some indicators or methods as opposed to others, and it was hoped that this would be a starting point for the reader to develop their own approach.

One of the indicators that was used is what I call the RSIosc, which is a modification of the Relative Strength Index, which was developed by Welles Wilder, and discussed in earlier articles. This oscillator is calculated by taking the difference between a 9-period simple moving average of a 14-period RSI and a 45-period exponentially weighted moving average of the RSI(14). Though this indicator can be used in many subjective ways in the scanning process, here it was just used in terms of being “positive” or “negative.” When the 9 SMA is above the 45 EMA, the oscillator is above zero and is positive, when the 9 SMA is below the 45 EMA, the oscillator is below zero and is negative.

The other indicator that was used in the scanning process is the MACD-His, which I have been using for over twenty years. This indicator is derived from the MACD, developed by Gerry Appel, who designed it primarily as a stock market timing indicator. It is made up of an MACD line and a Signal line. The simple interpretation is that when the MACD is above the Signal line, it is positive, and when the MACD is below the Signal line, it is negative. The MACD-His looks at the difference, or the spread, between the MACD and the Signal line and therefore moves above and below the zero reference line. Though many analysts, myself included, look for divergences between the MACD-His and prices, the scan looks only at whether it is above or below zero.

The last part of the scanning process looks at the Average Directional Movement Index, (ADX). Specifically, when the nine-period ADX, ADX(9), is above the 21-period weighted moving average, (WMA), of the ADX(9), it is rated as positive and it suggests the sector is trending; when it is below the 21 WMA, it is negative as it suggests a non-trending market. To summarize, sectors were selected using the following procedure:

Test all S&P Industry Groups–Weekly Data First
Select those groups where the:

  1. RSIosc > 0
  2. MACD-His > 0
  3. ADX (9) > 21 WMA of ADX(9)

In the second part of the scanning process, I took those S&P Groups that met the weekly scan requirements and tested them basis the daily data with the same parameters.

This generated a list of S&P Groups that are positive basis both the weekly and the daily data. This scan was run on 6/10/05, and the table below shows that ten sectors were selected.

Table1

On the table, I have listed the sectors, their price on 6/10/05, their highest and lowest price since 6/10/05, the price on 10/13/06, and then the greatest loss % since 6/10/05 and the greatest gain %. The last two columns will be discussed later, but one will note from the table that there were some dramatic swings in these sectors over the past sixteen months. Of course, anyone designing their own scan should realize that it needs to be run on a regular basis and that money management techniques should be applied to all investment or trading positions.

fig1

Figure 1

The greatest percentage decline was in the homebuilding sector, so a weekly chart of this index, (figure 1), looks like a good place to start. Each of the sector charts in this article will have a blue arrow marking the price at 6/10/05. In the next six weeks, the index gained another 24%, but has been lower ever since. By running this scan every week, homebuilding would have moved off the positive sector list the week of 9/9/05, when the RSIosc turned negative, (line B). Other methods could have also assisted you in avoiding loss in this sector. For comparison purposes, I have employed an 8% stop. This means that if the price drops more than 8% below the purchase price, then you would close out your position. Others would prefer 10%, and some 5%, but personally I would use a stop below a significant chart point that cannot be referenced objectively. As for the Homebuilding Index, it formed a major weekly head-and-shoulders top formation, which was completed the week of 4/28/06 when the neckline, (line A), was broken. This was the same week that the 8% stop would have been hit.

fig 2

Figure 2

The weekly chart of the life insurance group, (figure 2), looks much more positive, as at its worst, it was down only 2% and is now at its highs, up 25% from the entry point. The weekly chart shows that on 6/10/05, (blue arrow), it had just reconfirmed the breakout through resistance, (line A), from early in the year. It had a strong rally late in 2005, and has just broken out of a consolidation pattern, (lines B and C), that took twelve months to form. It shows no signs yet of a top, and the long-term uptrend, (line D), is well below current levels.

fig 3

Figure 3

The chart of the semiconductors, (figure 3), accurately reflects that often the sectors are very choppy. In June of 2005, (see arrow), the index had just moved above the previous two peaks, but was still well below the major line of resistance, (line A). The Semiconductor Index did rally about 8% in the six weeks after 6/10/05, but then turned sharply lower. It reached the 8% stop level on October 28, 2005, before starting another rally back towards the previous highs. As you will note from the chart, 2006 has not been any less volatile. In May 2006, it dropped below support at line C.

fig 4

Figure 4

The S&P Telecommunication Equipment Index, (figure 4), presents the ideal situation, as not only did it show up as positive on both the weekly and daily scan, the long-term chart formation was also well defined. On May 27, 2005, the downtrend, line A, was surpassed, which completed the 17-month triangle formation, (lines A and B). This sector pulled back 3% in the next four weeks, but then gained 31% in the next eleven months, peaking in April of 2006. The correction over the summer of 2006 was quite sharp as it took the sector just below the entry price. With the close as of 10/13/06, the sector is still up 24% as it rallied sharply from the August lows and is now challenging the highs made early in the year.

fig 5

Figure 5

Of course many of the stocks in this sector have done even better. The weekly chart above covers SBA Communications Corp., (SBAC), since early 2002. Once a sector shows up as positive basis, both the weekly and daily scan, then the same type of scan can be run on individual stocks in these sectors to isolate those stocks also rated as positive. Once this objective process is complete, I recommend adding the subjective input of analyzing the chart formations of the individual stocks. The SBAC shows that major resistance, line A, was overcome in early September 2004, and increasing volume confirmed the breakout, (circle 1). From late November 2004 though April 2005, the SBAC formed a continuation pattern, lines B and C, as it traded between $8.00 and $10.60. On May 7, 2005, it moved through resistance, (line B), completing the continuation pattern. Five weeks later, the sector also turned positive, (see arrow). As of the close on 10/13/06, the SBAC is up over 150% since June of 2005.

I hope this update and introduction to sector scanning will encourage you to think about developing your own process for scanning sectors and stocks. Though I am not a fan of purely automated trading (and particularly not “black box” systems) a scanning process such as this can help the trader or investor zero in on the stocks they want to analyze further. As I mentioned at the beginning of the article, no claims are made about the scanning process that I have discussed. In fact, I would encourage you to add in your favorite indicators either in addition or as a replacement for either the RSIosc or the MACD-His. In future articles, we will discuss other types of scans, including those which will help you isolate important volume patterns.

If you have a question about this article or would like to have a trading method discussed in more detail, I can be contacted at tomaspray@intershow.com.

Tom Aspray began doing computer analysis of the financial markets in the early 1980s. He helped to introduce many of the technical tools that are now very popular though his writings and lectures around the world. He now works as a private consultant and educator.

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