foxex: Investors Shift Towards Defensive Sectors

Chart Advisor | Focus on the Price

By John Jagerson, CFA, CMT

Thursday, February 07, 2019

1. Defensive sectors out performed

2. Growth estimates in Europe are a potential problem

3. Relative strength is close to a "risk on" breakout

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Major Moves

In the following chart, I have compared the SPDR Utilities EFT (XLU) with the S&P 500 using five-minute candles covering today's trading session. As you can see, there is a big difference in relative performance between the two asset classes. It may not sound surprising that utilities—a "defensive" sector—would be outperforming the S&P 500 on the day the market was falling, but it is actually an important sign that investor sentiment is still relatively stable.

If investors are aggressively selling equities, then utilities or other defensive sectors are likely to follow the trend. Conservative stocks and income payers may decline less in a market panic but they still decline. We should be a lot more concerned about bearish sentiment if all sectors were in decline at the same time.

Today I was interested in the apparent disconnect between what the headlines said about the market's drop and which stocks were actually in decline. For example, one of the most common "causes" blamed for the decline was a worry that President Trump and President Xi would not be meeting before the deadline for additional tariffs on Chinese imports in March. However, if that were true, we should have expected to see consumer stocks down a lot more on reduced margin expectations. However, even Walmart (WMT) closed higher today.

Euro Stocks

A bad day in the market is certainly disappointing and worries over trade and a potential government shutdown are not helping to create any momentum; however, intermittent consolidations are normal behavior for the market. In my opinion, the biggest issue that could really turn the indexes south is international growth which has a relationship with international trade. However, that may be a tougher problem that can't be solved by just postponing tariff deadlines.

The Euro Stoxx 50 index is sort of like the Dow Jones Industrial Average for Europe. As you can see in the following chart, the Euro Stoxx 50 failed at the 3200 pivot today after the European Commission downgraded its 2019 growth estimate for Italy to .2% from 1.2%. Economic concerns about Italy can put traders on edge because of the ongoing negotiations over Italian deficits, government spending and debt.

If the Euro Stoxx 50 index pauses at 3100 and moves higher again, we could see a bullish inverted head and shoulders pattern which would likely be seen as a new buying opportunity in the market and is therefore worth watching closely over the next week or two.

Read more:

What is the Utilities Sector?

What Makes a Stock Defensive?

Is a US-China Trade Deal a Sell Signal?

Risk Indicators - Relative Strength

From a risk perspective, most indicators are flat or moving slowly, except for the US dollar which has been frustratingly bullish this week. As the market declined and earnings announcements in Japan disappointed, the dollar rallied again today. This is the 6th advance in a row, which may start to impact earnings expectations if the dollar moves beyond resistance and closer to its prior highs.

Comparing the performance of risky assets (like small-cap stocks) to more conservative assets is a a great way to evaluate investor sentiment. I recommend using a relative-strength comparison to do analysis like that. For example, in the following chart, the price line represents the quotient of the Russell 2000 Small-Cap index divided by the S&P 500, which will rise when small-caps are outperforming less-risky large caps. In that respect, today's performance is better than it looked. Small caps continued to outperform large caps because they dropped less.

In the chart, you can see that the relative performance of these two asset classes has a long-term pivot point near .56 that should be seen as a breakout point where investors will make another shift towards riskier assets. The last time this study was under .56 was during the 2015 "earnings recession" and it broke above again in November 2016 as the market went on another run to the upside.

From a technical perspective, we can use a study like this to identify a point where investors are likely to start shifting in favor of higher prices. Right now, the study is headed in the right direction and a clean break of .56 could send the market much higher. Positive news about trade, an improving outlook for first-quarter earnings or rising energy prices could all be potential catalysts this month for a breakout like that.

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Bottom line: Focus on Forward Guidance

According to Zacks Investment Research, estimates for first-quarter earnings growth across the S&P 500 is now -2% compared to the same quarter last year. Although growth rates are anticipated to return to positive territory later in the year, the negative outlook puts additional emphasis on any forward guidance during this quarter's earnings season. I still think the underlying fundamentals support a quick recovery in the second quarter, but preparing contingency plans and watching for key breakouts are always a good idea.

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