Is a Major Top in Stocks Forming?Sep 26, 2012
Chad Karnes, CMT
Picking tops and bottoms is a dangerous game. A smarter move is to wait for trend changes before buying or selling. One way to do that is to utilize relative strength analysis.
In the early 20th century the famed speculator Jesse Livermore stated, "It was never my thinking that made the big money for me. It was always my sitting." Livermore recognized that overthinking and overtrading were often enemies of an investor. The appropriate place to be is either with the trend or sitting on the sidelines instead of hyper-trading.
One way to identify the trend's direction is through relative strength analysis. (I wrote an article about this method before here.) By looking at the S&Pís industry sectors, investors can recognize which stocks are leading the market higher. If those sectors are more aggressive or conservative, an investor can draw logical conclusions on the underlying trend and health of the market. Typically the more aggressive sectors will lead the market in an uptrend and the more conservative sectors will outperform the market in a downtrend.
The S&P 500 has nine ETFs that represent its major sectors. The more aggressive ones include the Technology Select Sector SPDR (NYSEARCA:XLK), the Materials Select Sector SPDR (NYSEARCA:XLB), and the Financials Select Sector SPDR (NYSEARCA:XLF).
Examples of more conservative sectors are the Consumer Staples Select Sector SPDR (NYSEARCA: XLP) and the Utilities Select Sector SPDR (NYSEARCA:XLU).
An Energetic Market
The energy sector is one of the more aggressive sectors, and often a leader in up trends. Interestingly, the relative strength chart below told us that it was indeed leading the markets in mid-August. The market's trend was bullish until XLE warned us of a reversal.
In the August ETFguide Newsletter, we displayed why the Energy Sector was a key to this marketís rally. We wrote, ďBy 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 (NYSEARCA:SPY) has been up this week and generally the last two months, but once Energy no longer leads, the market top will likely be confirmed."
The energy sector led the market higher and lower over the past few months. Its relative strength breakdown in early May helped identify the marketís change in trend from up to down. It then started leading the market again in June, supporting a short-term bullish trend change.
On 8/21 we published the below chart showing weakness that was forming on XLE. A few days later it confirmed its underperformance, and the market had a short term sell off to 1400 from 1425. A similar setup is occurring right now.
XLE resumed its bullish leadership by early September pointing to a continued market rally, and today the energy sector (NYSEARCA:XLE) is still showing relative strength, but just barely.
Once Energy and one other key S&P sector we are watching confirm their relative strength reversal and start to become laggards instead of leaders, then the market's (NYSEARCA:IWM) selloff this week likely will turn into something more than just a temporary hiccup.
The ETFguide Profit Strategy Update analyzes the sector ETFs to help us stay ahead of trends and provide actionable and tradable low risk setups. In tonight's forecast, I will take an in depth look at these sectors to see if this sell off is likely to turn into something larger Ė that could lead to much lower prices and quite possibly a crisis type of meltdown