Market Sector Review: Extreme Market Bifurcation

While the current outperformance of those select market sectors has been very enticing this year, the risk to investors comes if the “Reflation Narrative” falters for any reason. Those risks could come from a stronger dollar, falling inflation, or the realization that the overvaluation of these sectors has reached levels more historically extreme, given that these sectors have historically had some of the weakest revenue growth, particularly Energy.

With that said, since today is “Presidents’ Day” and the markets are closed, we will go through a technical review of each S&P 500 market sector, with a brief trading setup heading into next week.

How To Read The Charts

Using the S&P 500 Index as an example, this brief tutorial explains how to read the charts.

1. The red line is the daily price for the past 3 years.
2. The shaded areas are Bollinger Bands, which track the price’s standard deviation relative to the underlying moving average. In our examples, we are measuring price at 2 and 3 standard deviations from the 50-day moving average.
3. The green line is the 200-day moving average.
4. The shaded grey area in the background is a Williams %R reading, which measures short-term overbought and oversold conditions.
5. The bottom graph is a Relative Strength Index, which also measures overbought and oversold conditions.

Okay, let’s get to it.

Sector Review

Basic Materials

• Basic Materials broke through previous resistance and is now 3 standard deviations above the moving average. However, the trend remains bullish.
• Currently, the price is very deviated above the rising 200-day, and extension risk is high after a steep run into 53 to 54.
• With both longer-term readings at more extreme overbought levels, the risk of a correction is rising.
• Keep stops on trading positions at the 50-dma, which is now critical support.
• Action plan: Trim into strength, raise stops under 52 for tactical positions. Longer-term trend stop is near 47 to 48. Avoid new buys until 52 or 50 holds.

Staples

• Like XLB, Staples has also surged through previous resistance and is now well into 3 standard deviations above the moving average.
• Currently, the price is very deviated above the rising 200-day, and extension risk is high after a steep run into 88 to 90.
• With both longer-term readings at more extreme overbought levels, the risk of a correction is rising.
• Keep stops on trading positions at the 50-dma, which is now critical support and sits near the previous breakout levels.
• Action plan: Trim into strength, raise stops under 82 for tactical positions. Longer-term trend stop is near 79 to 80. Avoid new buys until a correction holds at either previous breakout levels or the 200-day moving average.

Industrials

• The chase also continues in Industrials, which is also 3 standard deviations above its mean. If you review the chart carefully, you will see that while these deviations can persist for some time, they eventually

  revert.

• Currently, the price is very deviated above the rising 200-day, and extension risk is high after a steep run into 173 to 174.

• With both longer-term readings at more extreme overbought levels, the risk of a correction is rising.

• Keep stops on trading positions at the 50-dma, but critical support remains at the previous breakout levels at 155.

• Action plan: Trim into strength, raise stops under 163 for tactical positions. Longer-term trend stop is near 153. Avoid new buys until a correction holds at either previous breakout levels or the 200-day moving average.

Financials

• Unlike our previous market sectors, the Financials sector has been under considerable pressure. XLF is now 3 standard deviations BELOW its mean, and is at levels that have previously constituted buying opportunities.
• However, the break below the 200-day moving average does provide near-term risk. Hold off on purchases until the moving average is recovered.
• With both longer-term readings nearing oversold levels, the risk of a deeper correction is subsiding.
• Keep stops on trading positions at 50, which is critical support from previous lows.
• Action plan: Keep a watch on financials for a recovery that reclaims and holds the 200-day moving average. Keep stops very close to current levels.

Consumer Discretionary

• Like XLF, the Discretionary sector has also been under considerable pressure. XLY has broken through its 50-day moving average and is approaching critical support at its 200-day moving average. Unlike XLF, XLY is not nearly as oversold, so the sector currently has more downside risk. Remain cautious with positioning.
• As noted, the 200-day moving average provides near-term support, and XLY needs to hold those levels to maintain its bullish trend.
• Both longer-term readings are approaching oversold levels, but not there yet, which suggests downside risks persist.
• Keep stops on trading positions at 115, which is the 200-day moving average.
• Action plan: Keep a watch on the discretionary to see if it can hold the 200-day moving average. Keep stops at that level for now until price action improves.

Healthcare

• The Healthcare sector remains in more neutral territory. It is neither grossly extended nor oversold, which keeps positioning stable for now.
• However, the deviation above the 200-day moving average is extreme, and the sector could be forming a top at current levels.
• With RSI at a more neutral level, keep holdings at current target weights but be mindful ot risks.
• Keep stops on trading positions at 150, which is the previous sell-off low.
• Action plan: Hold healthcare positions for now, but maintain around 150. If a rotation out of healthcare begins, it is a decent drop to the 200-day moving average.

Transportation

• Transportation stocks have been on a massive run since the “Liberation Day” lows last year. Transports recently peaked 3 standard deviations above its mean and appears to have started a short-term correction.
• However, the deviation above the 200-day moving average remains significant, so tighten up stops and take profits in the sector if you have not already.
• Both longer-term readings are starting to reverse from overbought levels, which potentially adds to current risk levels.
• Keep stops on trading positions at 95, the previous support level.
• Action plan: Take profits and rebalance the sector back to target weights. Keep stops on trading positions at the 50-day moving average with an understanding there is risk down to the 200-day.

Technology

• Technology has been the poster child of the selloff recently. Notably, the technology sector is trying to hold support at lows from last November. A failure to do so would imply potentially more downside risk.
• Notably, the 200-day moving average is a strong support level for both traders and investors.
• With both longer-term readings nearing oversold levels, the risk of a deeper correction is subsiding.
• Keep stops on trading positions at 135, which is the 200-day moving average.
• Action plan: If you failed to take profits previously in technology, it is a little late to do that now. Hold current positions with a stop at the 200-day moving average. Look to add to holdings if the sector can begin to improve relative strength, reclaim the 50-day moving average, and start to show an improvement in money flows.

Utilities

• As we discussed last year, the Utilities sector was hated, and no one wanted to own the “boring” stuff. That tone has changed this year, with XLU surging through resistance and pushing well above the 3-standard-deviation level.
• However, the recent breakout to new highs for XLU is encouraging and could foster further buying. However, the extension does pose trading risk.
• With both longer-term readings overbought, higher prices are likely to become more problematic.
• Keep stops on trading positions at the 200-day moving average, which is key support.
• Action plan: Utilities are caught up in the reflation narrative, but the fundamentals don’t support the speculation. Hold positions but keep stops at the 200-day moving average.

Real Estate

• Like XLU, Real Estate has also seen a sudden surge in buying interest, and money rotates from growth to value. However, a lot of the stocks in these sectors are trading more like growth than value. The extreme deviation above the mean in XLRE, like XLU, is a warning, but it can persist for some time. So hold positions but manage your risk.
• However, the 200-day moving average is nearby and provides a useful benchmark for both traders and investors to manage their risk exposures.
• With both longer-term readings nearing overbought levels, the risk of a correction is rising.
• Keep stops on trading positions at 41, which is the 200-day moving average for now.
• Action plan: Keep a watch on real estate for buyer exhaustion as the run is getting extended. Hold positions for now, but taking profits and rebalancing to target weights never hurts. The 200-day moving average remains key support.

Conclusion

The current bifurcation inside the S&P 500 raises investor risk as price leadership has shifted toward sectors with weaker fundamental momentum, as noted above. Energy, Utilities, Industrials, and Materials work best when inflation rises, rates rise, and growth stays steady enough to support pricing power. That is the “reflation trade” narrative, but recent economic reports are undermining it as growth slows, inflation and wages fall, and rates decline.

Furthermore, given that markets eventually trade on revenue and earnings growth rates, which foster valuation premiums, the Technology, Communications, and parts of Discretionary are seeing significant discounts to expected growth rates. As such, when capital crowds into slow-growth defensives and cyclical inflation hedges while selling the higher-growth complex, the index loses internal quality. As we have seen, breadth narrows, volatility rises, broad market rallies shorten, and drawdowns get faster once the rotation exhausts.

This setup also increases policy risk. If inflation data continues to cool or the market reprices the path of rates lower, the reflation trade tends to unwind quickly. Energy and Materials face demand risk; Industrials face order risk; and Utilities are exposed to rate sensitivity, especially if yields fall quickly after a risk event. At the same time, the growth sectors being sold often have the strongest balance sheets and the highest margins, so when selling pressure hits those areas, it often reflects de-risking rather than a negative impact on future growth.

If you are overexposed to the reflation narrative, consider taking some gains and reducing concentration. Tightening risk controls, rebalancing toward target weights, and starting to focus on quality growth and cash flow durability is a good start. If you are overexposed to growth, focus on trimming the weakest balance sheets first, then add back only after price stabilizes and leadership improves. The goal is balance, not a single macro bet.

Trade accordingly.

Lance Roberts is a Chief Portfolio Strategist/Economist for RIA Advisors. He is also the host of “The Lance Roberts Podcast” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, Linked-In and YouTube Customer Relationship Summary (Form CRS)

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