What Retail Sector Health Reveals

By looking at a specific sector or industry within the market, technical analysts are able to decipher bits of information specific to that industry and how it relates to the big picture. The retail sector will provide the analyst information on the consumer and on the market outlook for the consumer spending sector looking 3 to 9 months forward. The consumer spending sector is traditionally a leading indicator for the health of the economy. The reason being that the consumer feels the effects of employment and pay almost immediately and will adjust their spending habits accordingly. This is in addition to the fact consumer spending typically accounts for 70% of economic GDP in the US.

 

Consumer spending makes up the majority of the US economy.

 

You could look at sales figures for consumer spending and analyze the figures fundamentally. But this is only part of the equation. The other equation is future outlook as well as sentiment regarding the retail sector. The fundamental figures will not tell you how risky an investment is perceived to be, and we also know that many fundamental readings are prone to randomness and marked by long periods without new information updates. By looking at the retail sector through technical analysis we gain an inside look into perceived future consumer spending and therefore the economy.

 

Retail sector ETF: XRT on 10-7-11, daily

 

The above chart shows what appears to be a normal bear market retracement. The Fibonacci numbers show an almost perfect 50% retracement from the July high to August low. There is also price support turned resistance right around this level too, strengthening retail resistance while simultaneously providing the potential for a powerful coil to the upside. A decisive break above 50 would signal that the retail sector is able to overcome resistance and indicate a positive outlook going forward. If and until this happens, it appears the larger overall trend is down as resistance and general market conditions weigh on this sector.

 

Some bright spots on this chart include a massive bullish engulfing candlestick pattern (circled), as well as relative strength and outperformance by XRT across the broad sector S&P. However, the relative strength is masked by a RS resistance at the red line indicating highs from July. As Market Technicians we know that trendlines, support & resistance, patterns, and even moving averages can be used to analyze other indicators. While both are certainly positive developments overall, keep in mind that with rare exceptions, all stocks sooner or later move with the overall trend.

The Dow Jones Utility Average is the Most Important Indicator to Watch Right Now

Recently I posted about what was going on in the Dow Transportation Average here, and how a Market Technician might form his/her analysis, make investment decisions, and advise clients. Today I will briefly examine the Utility Average and explain why it is so important and often goes overlooked, as well as describe why it is projecting a slightly bullish bias in current market conditions.

 

The Utility Average has been quietly roaring back..

 

 

A Bit of Background

 

The Dow Jones Utility Average is made up of 15 utility companies that are in the business of electric utilities, gas pipelines, telephone companies, and natural gas. You may see the components of the Utility Average here. Along with the Dow Transportation Average, it is one of the most important averages in existence today, and yet I feel many choose to overlook or disregard it. This is unfortunate for them. The average itself can be somewhat boring by typical investment standards, as it often moves much less than the Industrials and the Transports. Yet it has historically proved to be one of the most reliable barometers of the overall market as well as the Industrial Average itself.

 

Utility stocks are very sensitive to changes in interest rates because many of these companies require significant amounts of capital to finance their operations, and this means debt relative to equity. Falling interest rates or extended periods of low rates allow these companies to attain favorable financing and this directly contributes to their bottom-line. Not only do utility companies benefit directly from low rates, but the price of their stock benefits indirectly as well. Because utility companies pay out their profits in the form of substantial dividends, they are often compared to bonds. When yields on treasury and other bonds are low, the yields of utility companies relatively become more attractive. The opposite is equally true when interest rates are high and rising; this is negative for utility companies. Perhaps this will give you further additional insight as to why the Fed’s monetary policy is so important to the stock market, even if conditions may not have changed or appear positive.

 

A Major Technical Principle

 

One of the major technical principles that CMT’s are taught is that changes in the trend of interest rates usually occurs ahead of reversals in the stock market, and therefore the Utility Average typically will lead the Industrial Average, and therefore the market, at tops and bottoms.

 

For this reason I consider the Utility Average the “stealth average” since it often quietly goes about its business at the same time the broad indices are alive with activity and preoccupying many investors’ time. Is this what is happening now?

 

Periods When Utilities Lead Industrials at Tops

 

-1937

-1946

-1953

-1966

-1968

-1973

-1987

-1994

 

Periods When Utilities Lead Industrials at Bottoms

 

-1942

-1949

-1953

-1962

-1966

-1974

-1982

-1998

 

This is not to say that the utilities will always lead, because this is not the case. Oftentimes the peaks and troughs will coincide with the Industrials as has happened recently, and a few times in recent history they have lagged (1970, 1976, 2001). The chart below is the comparison between the Utilities and the Industrials side-by-side over most of the last decade.

 

Dow Jones Utility Average compared to Dow Jones Industrial Average; $UTIL is still rising.

 

You can see from this chart that the Utilities still appear to be headed up while the Industrials have formed an intermediate peak. Also an interesting note about the chart is that volume spiked massively in August when the Utilities briefly but violently sold off. This suggests there is a lot of pent-up demand for Utility companies, a fact confirmed by the quick recovery in Utility prices. The downturn in August doesn’t even register on the monthly chart above.

 

Weekly chart of the Dow Jones Utility Average with multi-year trendline and red parallel

 

As I write this the Utilities are only mere fractions away from a 3-year high. A 3-year high! And this is after all of the bearish economic news that has been plaguing the markets of late. While a new multi-year high does not signal a continuation of trend (nor is it a buying signal), it is a bullish indicator that we should pay attention to. The Utilities can diverge from the general market for only so long and the two must ultimately reach trend parity. This gives rise to the possibility that the broad market will follow the Utilities in time.

 

This concept of analyzing more than one average is what Dow Theory is all about. It should tell you the general market trend for all stocks. As previously stated a new high in one average is not a trend signal until the other averages confirm. When and if the the chart of the Utilities breaks down, one can confidently say the broad market trend is down. However, until that time it may be best to wait for confirmation to be signaled one way or the other, or implement strategies that make use of the strength in utilities.

The Past, the Present, with a Watchful Eye to the Future…

In the last article I espoused the benefits of the First Principles of technical analysis. Today I am going to look at the application of two of these, specifically area patterns and broad market theory. I will be examining the Dow Jones Transportation average – an average often cited as a leading indicator and a key component of Dow Theory – as to where it stands at present. I will be looking at a potential area pattern as it may be developing in the transports and how, as a CMT, one is taught to analyze. Now on to business.

 

The chart below is a 4-year chart of the Transports. You can clearly see the March 2009 low and the distinct Inverted Head and Shoulder pattern it formed. I have marked the minimum price target as well, which it exceeded, as well as double the price target. Head and Shoulders patterns will have a price target that is the width of the pattern – that is, the neckline to the head, added to the neckline. This goes for normal H&S patterns as well as inverted patterns. These price targets can only ever be established once the pattern is confirmed. This means that had you been watching the pattern developments in the transports as they unfolded in early 2009, you would have seen the first shoulder, the head, and then maybe the second shoulder all before any actual implications could be derived.

 

4-Year Weekly Chart of Dow Transports

 

This pattern took roughly nine months to develop. Because it took many months, its implications, when and if it confirmed, would be significant. As you can see, the pattern was confirmed and its effects were indeed significant. The minimum price target was reached and the double target was nearly reached. You can expect the price to reach between 1 and 2 times the target. The volume characteristics for the pattern were mostly inline with expectations as well, though they were somewhat muted. For an Inverted Head and Shoulders, you should expect the heaviest volume on the first shoulder and then you can expect it to level off thereafter.

 

Now let’s examine what is happening in the Transportation Average currently. You can see from the daily chart below a potential Inverted Head and Shoulders pattern developing. Because it is on a daily basis, any potential implications will be less significant in both the likelihood of a move and length of distance and time of a move. I want to stress that this pattern is a developing pattern, and that currently there are no implications and there will not be any until this pattern is confirmed. That means a decisive close above the neckline for three consecutive days. This pattern looks somewhat promising because of the volume pattern, which is heaviest into the first shoulder, as well as the fact that the transports last major pattern was an Inverted H&S. Oftentimes a stock will repeat its pattern (if only in degree) because the character of either itself or its investors or both remain the same over time.

 

Six month daily chart of the Dow Transports

 

Does that mean that our analysis, as it stands, is useless? Far from it. As a Market Technician you can extract data from the market on a day-by-day basis, a week-by-week basis, a month-by-month basis, and even a minute-by-minute basis for shorter working time frames. Knowing now that there is a potential Inverted Head and Shoulders developing, you can look specifically to see whether or not this pattern is confirmed or rejected. Since this is a daily chart, we will gain additional insight every day or every couple of days as it continues to develop.

 

Scenario 1

 

You can see from the chart the 4,300 level appears to be very important. A decisive break to new lows – below 4,200 – would indicate the break down of the pattern. This would signal to the Technician a continuation of the downtrend, and can be used as a signal to initiate short positions, or remain in short positions previously initiated.

 

Scenario 2

 

Should the transports reverse course and decisively break above the neckline at 4,700 – the pattern would then be confirmed and its minimum upside target given at 5,200. Of course this may still be a reactionary move in an otherwise down market, however the knowledge and implications of the confirmed pattern should aid any investor. A confirmed pattern would indicate a renewed rally, and would signal to shorts to exit their positions, longs to remain in their positions, and possibly new longs initiated on a short-term horizon.

 

Scenario 3

 

The pattern may neither break down nor be confirmed right away, but merely consolidate sideways as it waits for further direction. After a certain point the Inverted H&S pattern would be ruled out because long periods of consolidation are not synonymous with these patterns. At that point the Technician would need to evaluate any further (new) pattern developments as well as critically examine support and resistance levels.

 

Conclusion

 

Dow Theory is an essential element and First Principle of Technical Analysis. It states you must look at both the Dow Jones Industrial Average as well as the Dow Jones Transportation Average to gauge the overall market direction. Together these will tell you if the market is moving together (either up or down), is unsure of itself, or if it may be in the process of reversing its course. Today I have only briefly examined Dow Theory while looking at less than half of the picture to demonstrate how you can make use of developing patterns. My purpose is exploratory rather than exhaustive, in order that one might improve their technical skills.