Which Sectors To Hold And Which Sectors To Fold Part II

Earlier in the week I reviewed several US market sectors from the point of view of their potential strength or weakness. In this article I’ll cover the rest and then some. If you know what I mean by the term “Nirvana Template” you can skip the next paragraph and go straight to the Inflation/Deflation section.

The charts I am using feature what I term my “Nirvana” template. I call it that because it contains all of the key factors that go into a successful long-term analysis. Two windows contain absolute prices, including a 65-week EMA as an objective measure of trend, together with a long-term smoothed momentum (KST) that locates where we are in the cycle. A low and rising KST indicates an emerging bull, whereas a high and declining one prepares us for a possible impending bear market or an extended trading range. Similar measures are featured for relative action against the S&P Composite in the lower two panels. In an ideal world we want to identify situations where both KSTs are below zero and crossing their 26-week EMA’s as well as observing a trendline break or a positive 65-week EMA for the price and RS line. A good example is shown in Chart 9. The opposite example, during the formation of a top, is featured in Chart 3 withe the dashed arrow/line combination. I want to stress that is by no means a perfect approach, but following it on a consistent basis does place the odds in your favor. If you want to use this template yourself just click on one of the charts using this arrangement and save it as a chart style. Bearing all that in mind, let’s take a look at the sectors we missed in the previous article. First though, a few remarks on the relationship between inflation and deflation sensitive sectors and industry groups. Then we can progress to our first Nirvana template in Chart 2.

Inflation versus Deflation Sectors

A useful demarcation in sector work is to distinguish between inflation (earnings driven) and deflation (defensive) sensitive ones. The first category would include all resource-based sectors, whose profits are substantially affected by the ups and downs of commodity prices. Deflation sensitives would include beneficiaries of lower rates and troubled economic times, such as utilities and consumer staples. It’s also helpful to analyze the relationship between these two categories to see which side the market is currently favoring. Chart 1 does this by calculating the ratio between an inflation sensitive index of S&P Industry groups and a deflation sensitive one. It’s not quite clear but it does look as if the inflation areas are breaking out in favor of their deflationary counterparts. The ratio is already above the two converging trendlines but needs to do a little more work. The problem is that it’s currently overbought on a short-term basis and may need to correct. If so, that would delay any buy signal by the long-term KST and could send the ratio to new (inflationary) bear market lows. Let’s first look at some of these inflation beneficiaries to see how they may be able to take advantage of a more decisive upside breakout by the Inflation/Deflation ratio.

Chart 1

Energy

The Spider Energy, XLE, has not formed a base on either an absolute or relative basis. Moreover, neither series has yet crossed above its 65-week EMA. However, both have violated their 2014-6 down trendlines. That in itself is not enough to justify a switch from primary bear to bull but, combined with the flattening action of both KSTs, does indicate a substantial dissipation of downside momentum. Bottom line, quite bullish but certainly worth stalking.

Chart 2

Metal and Mining

The Spider Metal and Mining ETF, the XME has had a good run of late and is now quite overstretched and running into resistance. That resistance take the form of the extended red down trendline and the 65-week EMA. The RS line is also below two converging trendlines. Absent the successful clearance of this absolute and relative resistance, the most positive part of the chart emanates from the two KSTs, which are close to a buy signal.  It’s therefore likely that this ETF is in the early stages of building a base, prior to a more durable turn to the upside.

Chart 3

Materials

That base building process appears to be in a more advanced state of development for the Spider Materials, the XLB. It’s been going on for about a year and both the absolute and relative lines are close to an upside breakout. That could well be delayed because the third panel of Chart 6 shows that the price has recently experienced a short-term sell signal. If some ranging action or a small decline follows, that may well turn out to be the right shoulder of an inverse head and shoulders pattern, once the $46.50 level has been broken.

Chart 4

Gold

Gold mining, in the form of the GDX, is the leader of the resource based pack of ETF’s. That’s because the price and relative line have both broken to the upside and comfortably cleared their respective EMA’s. A positive absolute and relative KST rounds out the primary trend bullish case. Even the short-term KST in the bottom window of Chart 6 has started to rally again.

Chart 5

Chart 6

Technology

The Spider Technology (XLK) price and relative strength line are above their up trendlines and 65-week EMA’s, and are therefore one of the few groups or sectors that have not experienced major corrective activity in the last year or two. The weakest part of the chart comes from the bearish action of the absolute long-term KST, which has affected the price by pushing it into a trading range. At this point there is insufficient evidence to justify a sell.

Chart 7

Healthcare

Healthcare (XLV) has been one of the most consistently strong performers since the 2009 low. That now looks set to change, as both the price and relative lines have violated key up trendlines and their respective KSTs have gone decisively bearish.

Chart 8

Financials

The Financial ETF, the XLF, is in a similar technical situation to the healthcare sector, in that the absolute and relative lines have both completed tops and each series is experiencing a bearish long-term KST. The trend part of the equation could change to bullish in the event that both red lines are penetrated on the upside. However, the overbought and bearish KST in the fourth panel of Chart 11 says if this is going to happen it will likely be later rather than sooner.

Chart 9

Transports

The Dow Jones Transport ETF, the IYT, has experienced some serious corrective activity since it peaked in late 2014. As a result both KSTs, though still bearish, are in a position where they could reverse given a worthwhile rally. The price itself is trying to push through resistance in the form of the 65-week EMA and converging trendlines. Since the bottom panel of Chart 11 shows that the KST is overstretched and declining, it’s possible that the end of the 2016 rally is in sight. I am looking for a bounce in the RS line above the March high, since that would clear the down trendline and EMA. However, in the absence of such a development, it is wiser to assume that the series of declining peaks and troughs in this RS line are still intact.

Chart 10

Chart 11

Good luck and good charting,
Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group or its affiliates.