Rolling Defensive and What's NOT in Vogue

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Equities started Tuesday and ended Tuesday on a strong note with the DJIA finishing the day up 131.50 index points or 1.37% at 9,731.25, the S&P up 14.26 index points or 1.37% at 1054.72, and the NASDAQ 100 up 29.61 index points or 1.77% at 1705.25. Clearly, a lot of bearish position traders encouraged by the recent bout of stock market weakness found themselves on the wrong side of the surging stock indices, with panicked short covering the end result. Yet, the recent 4% decline in stock prices – a correction in the classic sense, actually saw a substantial number of issues coming materially off the highs. Internally, despite the S&P price of 1060, this is a market that is now internally a good deal weaker than the S&P mark of 1060 seen just a few weeks ago. The weakening is subtle but definite, and that suggests the latter innings of the rally are at hand. Instead of getting bearish, and perhaps jumping the gun on a stock market top, our suggesting to most traders is to enter trend following mode, and watch closely for signs of an altered market complexion. The key in understanding a market residing in the late innings of a powerful move up is to observe the changes in ‘risk appetite’. Factually, a few weeks back, all kinds of low-end priced stocks were having huge one-day rallies. Names like Delta Petroleum, AMR, Connexant Systems, Boise Inc., Entercom Communications, Avis Budget, STEC Inc, Whole Foods, Valueclick, UAL, Brocade, Triquint Semiconductor, Radio One, Air Transport Services, Kirkland’s and especially some of the biotech’s, and the financials with names like, AIG, Fannie Mae, Citicorp, and Freddie Mac. Even sickly CIT had a brief fling with a few 20% up days. A few years ago during the cyclical bull market, we saw the same phenomena play out on a grander scale with low priced leadership exploding in upward parabolic fashion with names like J-2 Communications, Taser International, EBAY, I-Village,, Ask Jeeves, Websense, and TravelZoo all soaring, and then collapsing well ahead of the final peak in the major averages. A lack of buying interest in low priced stocks can be a major symptom of an underlying change taking place within the stock market, and it usually reflects a market getting more defensive.

A lot of these stocks are really poor quality, with no earnings, a dismal forward-looking sales outlook and yet, -- in a good market -- all was forgiven as prices were marked up dramatically from the lows. Our gut feel is that the days of ‘easy money’ are now well behind us, and that low priced stocks are going to start facing real head winds as a much harsher reality check is soon applied. Risk Appetite can be measured in other sectors as well. Going from the low end of the spectrum to the high end of the spectrum, we are always fascinated by the price action of high priced potential market leaders. These stocks can provide equally valuable insight as to the strength of an underlying trend. In the last few months, names like Google, Mastercard, Goldman Sachs, Baidu, CNOOC, Blackrock, Apple,,, Rio Tinto, Alcon, IBM have been important market leaders. Importantly, most of these high-flying, high priced leaders remain near their absolute highs and held up fairly well in the recent correction. Yet at the same time, most of these stocks seem to be losing upside momentum and struggling to perform well as the major averages recover.

In the last cycle, major high priced leaders such as Nyse-EuroNext, Nymex, CBOT, CME Group, Rio de Vale, Posco, Allegheny, Research in Motion began to struggle and then one by one, breakdown it was a sign that the end was near. These are what we like to call the “Creatures of Confidence” as each cycle has its own high priced ‘darlings’ that are held tightly in even the most staid institutional portfolio. In some cases, to suggest selling a stock like this is virtually blaspheme. Anyone remember Cisco Systems and Qualcomm in the 2000-2002 cycle? You couldn’t “not own” some of the high flying glamour names. Right now, our glamour index which is still made up of high prices names (like Goldman Sachs, Mastercard, Google, Apple, Alcon,, Priceline, RIMM) remains in a strong uptrend, but is nevertheless also showing definite signs of deteriorating momentum. This means it is time to pay close attention and see if these stocks can really move out to definitive new highs in the days and weeks immediately ahead. If they can’t and instead they congest up, it may mean that the rally is truly on borrowed time. As can be seen in the chart below, the GST Creatures of Confidence Index is still trending upward at a stronger rate than the broad market as evidenced by the rising Relative Strength Ratio in the bottom clip. As long as the Creatures of Confidence Index remains above the 50 day average the market remains in generally a bullish mode.

GST Creatures of Confidence, Middle: S&P, Lower: R/S Ratio

Above: GST Creatures of Confidence, Middle: S&P, Lower: R/S Ratio

Yet even as market internals weaken, we see a rotation taking place into low beta stocks. Boring names with large caps, and predictable earnings are slowly coming back into vogue. Among the sectors that have generally low beta and remain cash flow positive, Energy, Staples, Utilities and Healthcare are all starting to outperform. This type of rotation is indicative of large institutional money starting to get more defensive and rolling portfolios into lower risk names. For large institutions, the first choice for managers confronted with a more difficult market is to increase the percentage of bonds in the portfolio and strive for a more balanced portfolio. However, as many funds are not allowed to own bonds and must still remain heavily net long stocks, managers are forced to screen for low beta, low volatility names. Healthcare, for example, has long been a bastion of bear market refuge. While last year turned out to be a rout for Healthcare names, which moved down in line with the S&P, in the prior bear market, healthcare as a sector actually gained ground through much of the declining bear market phase.

2000-2002 Bear Market

Above: the 2000-2002 Bear Market which hurt the Tech heavy NASDAQ (thin line), during which Healthcare names performed well (bold).

In my work, I track several aspects of the Healthcare sector. In the chart below, I show the broad GST Healthcare Index along with the Relative Strength Ratio versus the S&P. So far since the March lows, Healthcare has recovered a little better than ‘in line’ with the market and as a broad category remains in a rising relative strength trend.

GST Healthcare Index, the Relative Strength Ratio versus the S&P

That said, within Healthcare there are any number of micro-groups. At present, medical information providers, technology companies involved in the healthcare space are at the high end of the Investors Business Daily group rankings, rated #14 out of 197 industry groups in total. Medical Hospitals come in at Ranking #41, and then Dental Services and Suppliers at Ranking #86 and #99, respectively. Yet, being contrarians, it is the low end of the spectrum which we regularly peruse, to which end, at #184, we see the HMO’s. Over the last few days, this sector has been especially hard hit as fears of the Obama Healthcare Plan continue to dog the sector. Yet, on our technical screens, these healthcare providers, hated as they may be, are showing some of the most oversold technical readings in years. In my work, I created a sub-group of all the HMO organizations in Yahoo Finance Sector List. I then computed a Medium Term ARMS Index for the space which amazingly on Monday, had a reading of 1.89, up from 1.71 the prior Friday.

GST Managed Care Index with Medium Term ARMS Index

Above: GST Managed Care Index with Medium Term ARMS Index

Other recent spike lows on the ARMS Index for HMO’s were seen on 3/6/09 at 1.94, and on 11/25/08 at 1.68 and in 2008, a reading of 2.86 on June 27th. The sector rallied on each occasion. Another indicator I like to watch when looking at Sub-Groups is the Medium Term Advance-Decline Ratio. Here again, where the HMO’s are concerned, the Monday close this week came in at .62, which is highly consistent with other oversold values as follows: .58 on 11/21/08, .54 on 6/21/08, .61 o 4/27/06, .68 on 2/14/03 and .68 on 8/16/99.

GST Managed Care Index with Medium Term Advanced/Decline Ratio

Above: GST Managed Care Index with Medium Term Advanced/Decline Ratio

Going back a bit further, I note that during the 2000-2002 bear market, HMO’s actually did very well as there were no overhanging issues threatening the bottom line. At present, the sector index remains above its 200 day moving average and seems to be pulling back to that moving average from above. On a Relative Strength basis, the R/S Ratio has fallen to near the lower long term trading band suggesting that perhaps a better period of performance could lie at ahead. Along with Consumer Staples and Utilities, the depressed segments within Healthcare are area’s that could be worth watching for those interested in following the institutional herd and playing a potential rotation into more defensive names.

S&P 500, Middle GST HMO Sub-Index, Lower: R/S Ratio of Managed Care versus S&P
Above: top clip the S&P 500, Middle GST HMO Sub-Index, Lower: R/S Ratio of Managed Care versus S&P.

 DJ Utility Average, Middle: Relative Strength of Utils versus S&P, lower, RSI on R/S Ratio

Above: DJ Utility Average, Middle: Relative Strength of Utils versus S&P, lower, RSI on R/S Ratio.

Finally, the stodgy old Utility sector (#178 of 197 in IBD Rankings) may also be headed for new life as we see that the R/S Ratio of Utilities versus the S&P seems to be near an important low. Plotting the Welles Wilder 14 day RSI on the R/S Ratio of Utilities to SPX, I see a bullish divergence, and like Healthcare, attendant oversold values. Does any of this guarantee a turn toward defensive names? No, but it does seem like these could be glimpses of directionally the kind of new trends we may see coming next. For now, the market still gets the bullish nod, but the bull is weakening and may be nearing its final breathing point in the weeks just ahead. When it does roll over, defensive sectors will almost certainly be the place to be, as can be seen by the way the R/S Ratio of Utilities to SPX soared last year, mimicking the price action of the VIX. For now, these other sectors are overlooked, and probably not on the radar. In my experience that is always a good time to start watching.

VIX Index (top) and lower: R/S Ratio of Utilities versus SPX

Above: the VIX Index (top) and lower: R/S Ratio of Utilities versus SPX.

That’s all for now,

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About Frank Barbera CMT