Lately, the volatile market has investors worried about rising rates, a rising dollar, a global slowdown, and a possible trade war. One of the strongest headwinds was the midterm elections, but that’s now in the rear-view mirror with Democrats winning the House and Republicans keeping the senate.
It turns out that the market actually viewed the gridlock result as a positive, with the S&P 500 gaining 2.12% the following day. But the S&P 500 still has a lot of work to do to return to the highs. There was a lot of technical damage done in the recent sell-off. Essentially, the S&P 500 has been able to briefly move back above the 200-day moving average but is having trouble gaining traction above the 2,820 level. Momentum stocks, specifically in technology, have seen strong outflows and corrections larger than 20%, putting them in the bear market territory.
Given that portfolio managers always need to be invested and just can’t sit on cash, we’ve identified these two sectors as the most likely areas where money will be put to work: Utilities and Consumer Staples. Both are composed of low-beta defensive stocks.
The S&P 500’s trend higher has been broken: held at 2,600, it briefly moved back above the 200-day moving average, and is seeing resistance at 2,820. It seems that moving lower is the path of least resistance, as investors who bought equities at higher levels will be waiting to break even to sell their shares, ultimately increasing resistance to the upside. Additionally, we have a bearish RSI divergence, indicating that momentum is getting weaker. For the S&P 500 to move higher, I believe we need to consolidate, build a base, and slowly grind back to the highs. Right now, a move lower looks most probable with the bears in charge.
Utilities Select Sector SPDR ETF (XLU)
After looking through the charts of all the different sector ETFs, the Utilities sector stands out as an area that is ripe for a breakout. The ETF has been trying to get through the $55 level since back in August, while making higher lows after testing the 200-day moving average. Additionally, the XLU is showing strong relative strength versus the S&P 500. Given the recent volatility in growth and momentum names, we’ll likely see portfolio managers rebalance positions. Although we’re in a rising rate environment, the positives of holding Utilities – slow and steady long-term gains (which include hefty yields) – clearly outweigh the negatives. Another strong downturn in the broader market will likely lead to the XLU breaking-out and making a run to 52-week highs of $57.23.
Consumer Staples Select Sector SPDR Fund (XLP)
Consumer Staples is another promising defensive sector, comprised of companies that produce items which consumers continue to purchase, regardless of the economy. The ETF is trading firmly above all three moving averages and has already broken out through the $55 price level – a prior cycle high. I expect continued strength and a move to $59.
Breaking down XLP’s holdings, Procter & Gamble (PG) is the most heavily weighted stock in the ETF at 13.18%. PG looks very strong and is marginally off the 52-week highs. PG has a lot of factors working in its favor that indicate the bulls are in charge. The stock has a strong trend upwards (since gapping higher on October 19th) with very strong volume, due to its earnings release and coupled with an upgrade by JPMorgan (from Neutral to Overweight). Additionally, momentum is strong (RSI 72) and the stock is ready to make another move higher relative to the S&P 500.
What does it all mean?
I expect all moves higher in the broader market to be sold down. I don’t believe that the worst of the volatility and the recent sell-off is over. We haven’t seen a capitulation of extreme panic or the flush-out of sellers. The market has rebounded enough to give investors hope of a return to highs. I remain optimistic long-term, but the price action, specifically in technology comprised of growth and momentum names, has not been encouraging. Additionally, a rising dollar, rising rates, and trade war fear all support the bearish thesis. Clearly, portfolio managers will have to get defensive in order to stay invested and mitigate risk. Money will likely flow into the XLU and XLP until we retest the lows in the broader market (S&P 2,600) and begin to see strength in growth names.
Rodney Raanan is Q4’s Equity Strategist and Director, Advisory. He writes Q4 blog’s monthly commentary on emerging markets and sectors.