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Point & Go Figure: Who's the Boss?



For equity traders, it is very important to understand who's the boss in the market at any given time. Relative strength is critical to generating alpha.

One of the reasons I like point and figure charts is because they give signals that are unambiguous. They are either positive or negative, on a buy signal, or on a sell signal. Now, this does not mean they only give 100% correct signals. Remember, we are dealing in probabilities, not certainty.

Recently, Minyan Ron forwarded me a Barron's piece written by the savvy technician Michael Khan. In the article, Mr. Khan took a look at whether it is time to get aggressive or defensive in the stock market using a proxy for technician Boris Simonder's Market Offense Indicator. What he did was look at several exchange-traded funds (ETF's), dividing the product of technology and cyclical ETF's by that of healthcare and consumer staples ETFs.

As you know, I have my own methodology that I use for evaluating overall risk in the stock market, but I believe looking at relative performance via point and figure tools is very helpful in evaluating longer-term performance trends. Importantly, especially for the long-only trader (and there are many of those out there), these tools can cushion downside moves and help identify areas from which to potentially generate alpha when lower-risk market conditions are present.

Below are four ratio charts constructed using the Amex Technology Select SPDR (XLK), the Amex Healthcare Select SPDR (XLV), the Amex Consumer Staples Select SPDR (XLP) and the Consumer Discretionary Select Sector SPDR (XLY).

Amex Technology Select SPDR (XLK) vs.
Amex Healthcare Select SPDR (XLV)
This ratio does not change often, but when it does reverse, the signals seem to be significant. It reversed up on Nov. 4, 2002 and remains nowhere close to a reversal down. Over that time period the XLK is up 39.57%, compared to 14.76% for the XLV.

Prior to that, this ratio reversed up on July 14, 1999, and reversed down on May 10, 2000. When the ratio was positive over that time period, in favor of the XLK, the XLK was up 11.55%, while the XLV was down 3.48%. From May 10, 2000 to Nov. 4, 2002, when the relative strength favored the XLV, the XLK was down 67.34%, while the XLV was down 5.19%.

Amex Technology Select SPDR (XLK) vs.
Amex Consumer Staples Select SPDR (XLP)

Consumer Discretionary Select Sector SPD (XLY) vs.
Amex Healthcare Select SPDR (XLV)
This ratio reversed up on Oct. 14, 2003 and after peaking last November, is getting closer to a potential reversal down, which would suggest a period of outperformance for the Healatchare over consumer discretionary. Since October 14, 2003, the XLY is up 12.31%, compared to 10.65% for the XLV.

Consumer Discretionary Select Sector SPD (XLY) vs.
Amex Consumer Staples Select SPDR (XLP)

The reversal up occurred on Nov. 14, 2001, and still not close to a reversal down, holding steady since peaking in December 2003. Since Nov. 14, 2001, the XLY is up 23.35%, while the XLP is down 7.43%.

People often talk and write about rotation in the stock market. Rotation can happen intra-day, daily, weekly, even monthly. But the migration on short-term time scales is difficult to stay ahead of, let alone follow. The relative strength charts above, show longer-term rotation, and most importantly, they illustrate it in a manner that is both unambiguous and unrelated to conventional wisdom. For example, everyone (and I include myself in that "everyone" category) "knows" that consumer discretionary is doomed on a macro scale, and that consumer staples should outperform as the consumer cuts back. The problem is, according to the stock market based on these ETFs, that thesis has yet to play out, or even begin to show up. We can guess all we like as to when the inevitable does occur, but might it not be easier and less stressful to simply allow the market to tell us when that is happening?

If you would like a chart reviewed, let me know here.

I have added text and illustrations to the charts where necessary.

All charts courtesy Dorsey, Wright & Associates.

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No positions in stocks mentioned.

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