ENERGY STOCKS CORRECT FURTHER -- THAT MAY HINT AT OIL WEAKNESS -- DEFENSIVE LEADERSHIP STILL FAVORS STAPLES, HEALTHCARE, AND UTILITIES -- NO SIGN OF A BOTTOM YET IN FINANCIALS

ENERGY STOCKS CONTINUE DOWNSIDE CORRECTION ... A big drop in energy prices made energy the day's weakest sector. Actually, energy stocks have been correcting for the past two weeks. Chart 1 shows that the Energy SPDR (XLE) broke its 50-day average a couple of weeks back on heavy volume. Today's decline puts it within striking distance of its 200-day average (red line). The current level of the 200-day line coincides roughly with the late April low at 78.22 and the late February peak at 78.59. Whether or not the XLE is able to hold over those levels (and its 200-day line) will determine if this is just a short-term energy pullback or something more serious. On July 3, I showed the Sector Rotation Model and suggested that with material stocks peaking, energy could be the next sector to roll over. That process may be starting. Given the correlation between energy shares and crude oil, a breakdown in the former could hint at more selling in the latter. Chart 2 shows the United States Oil Fund tumbling more than 4% today -- and on very heavy volume. Any decisive close below the 50-day line would be further confirmation that crude oil prices may be starting to weaken. Chart 3 shows the US Natural Gas ETF already in a downside correction.

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SECTOR ROTATION MODEL FAVORS STAPLES, HEALTHCARE, AND UTILITIES ... As I explained in my July 3 article on sector rotation, basic materials and energy are usually the last to peak in a bear market. Chart 4 shows the Materials ETF (blue line)) starting to drop sharply in mid-June. The Energy SPDR (black line) started dropping a couple of weeks ago. The second half of the earlier article showed that the next three groups to pick up the sector rotation baton are consumer staples, healthcare, and utilities. Although none of the three have shown big gains since the start of the year, they've done pretty well since mid-May. Chart 5 plots the three related ETFs relative to the S&P 500 (black line). All three have done much better than the broader market. The best of the three has been healthcare which we've been writing a lot about lately. In fact, healthcare was the day's top sector.

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NOT MUCH RELIEF FROM FINANCIALS YET ... Relative strength by the three previous defensive groups is normally associated with an "Early Contraction" phase of the business cycle. A sign that the economy has moved into a "Late Contraction" phase is rotation into consumer discretionary and financial stocks. So far, there isn't much sign of that. If energy stock do start to fall, it will be interesting to see where most of that money rotates to. And how the market reacts to that.

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