Diary of a Financier

SPX Analogue Says It’s Time to Play Defense

In Capital Markets on Mon 15 Oct 2012 at 14:54

The S&P 500 (SPX) has continued to follow the 2q12 analogue since my last update. To be sure, a Head & Shoulders top has not materialized as expected, but the priceaction and indicators are both still tightly tracking the bearish analogue. Remember, the April 2012 top was not a classical pattern, but a tilted H&S. The formation since September’s high has been even more lopsided than its predecessors–closer to a double top–but H&S tops are popping up in other broad indices. In particular, the NASDAQ’s H&S has already materialized, having fallen through its neckline en route to a 4.6% correction (as it stands today).

In the daily SPY chart, you’ll notice a bear channel has developed. According to the analogue, this recent bounce off trendline support fades quickly, giving way to a steep selloff:

SPY 2q12 v 4q12- analogue shows this bounce off trendline support will fade and support will break

Further, bear divergence is still looming in the daily & weekly fractals:

SPY daily/weekly/monthly- bear divergence still looming large in daily & weekly fractals; 2007 precrisis analogue suggests another crash could occur in 2013

This is the point in time at which an active manager starts working on his sector rotation. It’s time to liquidate the cyclical, levered, beta subsectors like Energy (XLE) and Industrials (XLI) in favor of defensive spaces like Utilities (XLU) and Healthcare (XLV), followed closely by Consumer Staples (XLP).

The defensive rotation is the historical precedent. I use that term cautiously, because historical precedents blow-up once the mainstream acknowledges them as such. From a static standpoint, XLU has grown expensive in terms of valuation. People will pay a premium for cashflow—not just during corrections, but also during low-growth economic environments like the last 5 years. I don’t think I’ll use XLU during this correction, because its multiples have expanded to premium levels on a relative & historical basis. With the Presidential election’s potential effect on Healthcare, I don’t feel safe in XLV either–a higher risk premium and higher volatility can be expected. I’m left with XLP and cash as risk-off bastions.

One last note: I wouldn’t expect much carnage in the Technology (XLK) space hereafter either. Last week, I noted that the NASDAQ ETF (QQQ) has already retraced 38.2% (a Fibonacci level) of its rally since June 2012’s low. While tech isn’t where I’d broadly allocate capital right now, that’s part of why I look to XLK to be a leading indicator of equities’ eventual bottom–one of the first sectors to rally out of a nearby trough.


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