What's Behind the Stock Market's Rally?Aug 17, 2012
Chad Karnes, CMT
Using sector ETFs to dissect the market's internals can help keep you on the right side of the trade. The financial and energy ETFs have been leaders the past few months and could point to a future trend change.
Stocks continue to rally, but for how long? After 7 straight days of sideways closing prices between 1400 and 1406, the market resumed its uptrend and seems invincible. Below, I lay out a case of why the upside is likely to continue until one key event occurs.
Bottoms Up or Top Down?
Market analysts usually take one of two approaches in identifying stock market trends. They either look at the market from a bottoms-up, sum of all parts, point of view. Or, they perform a top-down, more macro, look at the markets.
In a bottoms-up analysis, an analyst researches individual stocks and comes to a conclusion on how it all adds up by researching the companies at the ground level. In a top-down approach, an analyst looks at the market as a whole and decides how it will affect the individual components from a bird’s eye view.
Neither technique is perfect, and both have some flaws. For a bottoms-up analyst to form an opinion on the market as a whole, it requires studying a large amount of individual stocks, summing their parts, and then coming to a conclusion on the market’s intentions. This requires a lot of resources and time and still neglects most of the macro level analytics.
For a top-down analyst, themes and events may be taking place at the ground level that may not be noticed perhaps making the analyst “late to the game” and missing out on key turning points.
I suggest a compromised third option.
A Better Alternative?
If individual stocks are at the ground level and broader based vehicles, like the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) are at the top level, then using a combined approach, looking at the mid-level may be a better strategy. One way to split the difference is to analyze the 9 sectors those individual stocks are a part of.
The S&P 500 has 9 sectors including the Energy Select Sector SPDR (NYSEARCA:XLE), the Consumer Staples Select Sector SPDR (NYSEARCA: XLP), the materials Select Sector SPDR (NYSEARCA:XLB), and the Financials Select Sector SPDR (NYSEARCA:XLF).
An Energetic Market
In the August ETFguide Newsletter and shown in the chart below, we displayed why the Energy Sector was key to this market’s rally. We wrote, “By looking at the sector leaders and watching for those leaders to become laggards, we are able to get ahead of trend changes and see warning signs before the broader market shows them. The S&P 500 has been up this week and generally the last two months, but once Energy no longer leads, the market top will likely be confirmed”.
Click here to view an updated chart.
In the August newsletter the energy and financial sector analysis showed how they led the market higher and lower over the past two months. Their underperformance and breakdown in early May helped identify the market’s change in trend from up to down and we are expecting a similar event at the market's next juncture.
Today, the energy sector continues to lead this market higher while the financials are performing with the broader market. Until both Energy and Financials break down, the market likely will not top.
The ETFguide Profit Strategy Newsletter analyzes the sector ETFs like the XLF and XLE to help us stay ahead of trends and provide actionable and tradeable low risk setups. Whether you follow the bottoms up or the top down techniques, adding sector relative strength analysis may help bridge the gap between individual stock picking and broader macro analysis.