X-Raying the Sectors (Part 1)

05/06/2010 10:03 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Given the stellar performance by stocks in 2009, few were expecting that stocks would be as strong as they have been in the first quarter of 2010. The Dow Industrials were up 5.6%, the S&P 500 up 6.45%, and the NASDAQ Composite up 8.5%. Of course the small caps were even stronger as the S&P 600 was up 14.6%.


Figure 1 - Click to Enlarge

For those who follow my daily charts on MoneyShow.com, this should not have been a surprise since I typically look at the relative performance analysis of the S&P 600 and S&P 400 every few weeks. This is one of the stronger tools in my sector analysis toolbox, so let’s have a quick review.

The RS line above shows the ratio of the S&P 600 to the S&P 500. When it is rising, the S&P 600 is performing stronger than the S&P 500, and when it is declining, the S&P 600 is weaker than the S&P 500. This can be run on any time period, though I start with the weekly data and also use a 21-period WMA of the RS. The RS was in a downtrend in 2008 (see line a) but turned up in early-March 2009. With the weekly close on April 3, 2009 (line 1), both the RS downtrend and it’s WMA had been overcome. The RS stayed above its WMA until October 23, line 3, when the RS dropped back below its WMA and stayed below it for the next eight weeks. The higher close the week ending December 18 was above the short-term downtrend, line b, and also pushed the RS back above its WMA (line 3). Currently, the RS is well above its rising WMA and continues to make higher highs. Therefore, the intermediate-term outlook for the small caps is still clearly positive.

Despite the strength in the overall market, many industry groups failed to participate in the rally over the past month. In this article, I would like to review some technical methods that you might use to X-ray the industry groups and better time your entries and exits. Since the March 2009 lows, the major indices have continued to move higher as sectors have continued to rotate leadership. In some of the past market cycles, a sector or industry has stayed strong for a year or so, but since the March 2009 lows, many of the rallies have not lasted more than a few months. As some industry groups have formed short-term tops, other industry groups have taken over the leadership, maintaining the market’s overall uptrend. In this type of rolling correction market, additional methods cane be used to fine tune entries and exits as the weekly RS analysis is often not fast enough to catch two- to four-week corrections where an industry group could drop 5% -10%.

One of my favorite indicators for determining whether a market is at a good point to buy or sell are the starc bands that were developed by the late Manning Stoller, who was a pioneer in the banding analysis. Manning developed these bands after much experimentation and testing, concluding that these bands—derived from the average true range—could be used in any market and on any time frame. He determined that the starc bands would contain about 90% of the price activity. Therefore, they are used much differently than Bollinger Bands or Keltner Channels. The upper band is calculated by adding two times the 15-period ATR to a six-period simple moving average, while the lower band is determined by subtracting two times the 15-period ATR from the six-period simple moving average. If prices are near the upper, or starc+ bands, then it is a high-risk time to buy and a low-risk time to sell. Conversely, when prices are near the lower starc bands, or starc-, then it is a high-risk time to sell and a low-risk time to buy. Personally, some of my worst trades are often the result of a bad entry point—not my analysis of the market—and I avoid many of these when I follow the starc bands because they can keep me from taking a trade.

NEXT: A Technical Look at Some Prominent Sectors

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Figure 2 - Click to Enlarge

The Dow Jones Food and Beverage industry group was quite strong from early 2006 to late 2007 with a gain from high to low of over 35%. In addition to the starc bands, I also like to monitor the percentage that the industry group is above or below its 34-period simple moving average. Below the chart is a plot of the percentage that closing price is above or below its 34 SMA, and when the close and the SMA are the same, it is at zero.

In March 2006, the Food and Beverage stocks moved above resistance from the past year, and in four weeks, reached the upper weekly starc band. It was 2.86% above its SMA. The rally stalled, and in five weeks, the index had dropped back to its SMA, point 1, as the percent close dropped back to the zero line (point a). The low that week was at 237 with starc- at 234.3 and the starc+ at 249.9. Therefore, the sector was back in the lower-risk buying area. The following strong rally took the index back to the starc+ bands (point 2), which were tested or exceeded for three consecutive weeks, and the percentage close was at 5.3%.

By early July, the index was 4.5% lower with the index much closer to the starc- band and the percent close was down at 1.67%. The next rally lasted ten weeks as the percent close moved up to 5.95% and the highs were within 1% of the starc+. The index stayed in the upper half of the range until February 27 when global markets plunged. This decline took the index back to the lower bands, point 4, and the percent close back to zero (point b). Seven weeks later (April 20), the index closed above the starc+, point 5, as it had gained 8.7%. Some of the individual stocks did much better as Archer Daniels Midland (ADM), for example, was up 27% during this period. The high in the index coincided with a percent close reading of 6.8%. The index then traded sideways for almost three months.

This brings up an important point regarding starc bands because when a stock or index is near either starc band, it doesn’t always reverse. Sometimes it will relieve the price extreme by just moving sideways. It took until the middle of August to get the index close to its starc- band (point 6) and the percent close was at 0.40%. Before the end of the year, point 7, the index got fairly close to the starc+ bands with the percent close over 7%. As the stock market dropped in January 2008, the index closed below the starc- band and the percent close declined to -4.5%. As the chart indicates, this was a horrible time to sell as the index moved sideways to higher for the next few months.

NEXT: Technical Analysis of More Tradable Sectors

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Figure 3 - Click to Enlarge

Steel, as part of the materials sector, has done quite well since the March lows as the chart of the Dow Jones Steel index shows a steady, but not steep uptrend. There were several good entry points once the low was completed. In June, the steel stocks pulled back to test the 34 SMA (line 1) as well as the breakout level on the chart and the percent close dropped from over 33% to 4.8%. The SMA was again tested in late October before a strong rally into the January 2010 highs. The week of the highs (line 2), the Dow Jones Steel Index reversed to close lower after testing the starc+ band while the percent close had already turned lower, dropping from 30% to 20%. This suggested that it was a good time to take some profits in the steel stocks.

The percent close was back to zero in February before the index rallied to a new high in early April. It has since turned lower while the S&P 500 has moved higher. There is major trend line (line a), moving average, and starc- band support in the 240-250 area.

The DJ Managed Care index has been declining for the past six weeks as the close last week at 316 was below its SMA. There is trend line and starc- band support in the 290-300 area. The combinations of the starc bands and the percent close have helped identify a couple of key turning points. The index closed on its 34 SMA in early October (line 3) and the index was in the lower part of its starc band range. The managed care stocks rallied into the New Year as the Dow Jones Managed Care Index hit a high of 380 the week of January 16 (line 4) before reversing to close at 355. The percent close had peaked the prior week, and since these highs, the index is down almost 17%. During the same period, the S&P 500 was up 3.5%. Both of these industry groups will be worth watching over the next month or so as they have reached important support.


Figure 4 - Click to Enlarge

In Part 2 of this lesson, we will look at some industry groups and stocks that look interesting for the summer months, but right now, take a peek at one industry that is at the top of my list. On January 15, I noted that the Dow Jones Gambling Index had moved above 16-month resistance, so let’s look at how this industry has performed since the 2009 lows.

After a 200% rally from the March 2009 lows, the index corrected into early July, line 1, as it tested the 34 SMA. The index again peaked in September (line 2) as it reached the starc+ band and the percent close was just below 70%. Over the next six months, the index formed a triangle formation, lines a and b, which was completed at the end of March. As prices reached the apex of the triangle formation, the percent close dropped down to the zero line, where it stayed for several weeks before turning higher. Once the triangle was completed, the starc+ band was quickly reached and has been re-tested for the past month, suggesting a pullback is likely. A decline back to test the 370-380 area should provide a good risk/reward entry.

We will do some more X-raying on various sectors in our next trading lesson.

Tom Aspray, professional trader and analyst, serves as video content editor for MoneyShow.com. The views expressed here are his own.

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