Trader’s Narrative

The spring rally began in early March with the financial sector taking leadership and rising from a death spiral. The Philadelphia Banking Index (BKX) rallied with such a ferocity that in about two months time it had more than doubled.

In fact, by early May 2009, the financial sector had gone up by an astronomical 135%! Meanwhile, the wider market index, the S&P 500, had only managed a 35% increase. On its own, that was very impressive rally but it pales in comparison to the banks.

The banking sector is now 13.35% of the S&P 500 - it reached a low of 8.57% on March 6th (to see more historical data and graphs check out: Historical Weight of Financial Sector.)

But while the S&P 500 went on slightly higher in June, the financial sector as measured by the Philadelphia Banking Index (BKX) started to lag. This was the first time in many months that it didn’t move in lockstep with the general market.

So if the Banking Index (BKX) has given up leadership, which sector is driving the market higher?

Currently the Semiconductors (SOX) is going strong with Information Technology being the largest sector of the S&P 500 at 18.3%. As well, Transportation and Energy sectors continue to have relative strength. The question is, is this a normal sector rotation or does the weakness in the important financial sector mean that the market has lost an important leadership sector and will weaken as a result?

Who could have imagined that with crude oil at +$110, the transports would be one of the highest relative strength sectors out there?

Well, if the stock market was strictly logical we would have figured it all out centuries ago. This is exactly what makes trading so fascinating.

Bullish Percent
The recent swing low was in early January, when the bullish percent for the sector reached a measly 5%. Five percent!

Do you know the last time they were that low? Try July 2002.

But since you’ve read my post about timing the market with bullish percent charts, you know all about that and of course, took obscene advantage of it. Of course.

But there’s more going on here. Take a look at this chart:

The top chart shows the relative strength of the transports (to the S&P 500). Notice the higher lows and the higher highs. Then check out the completed head and shoulder formation with a nice quick retest of the neckline.

Believe it or not, it has already made it to the October 2007 highs. In contrast the Dow Jones Industrial average is still well below that area on its chart.

Dow Theory
According to Dow Theory, major signals are given when the two major sectors (sometimes along with the third: utilities) confirm each other.

While the recent action is not bullish per se, at least according to strict Dow Theory, it sets up what is called a “non-confirmation” - in this case, for a decline. That is, because the Dow Transports didn’t confirm the lows that the Dow Jones Industrial Average reached but instead headed up.

What would be truly bearish, according to Dow Theory, is if both the Dow Jones and the Transports print prices lower than their January levels.

So right now what we have is simply the potential for a buy signal, if the Dow Jones continues to rally and rises above its February highs.

On his blog, Dr. Steenbarger looked at how professional traders differ from amateurs. One of the key differences was information flow:

2) Information Networks - The pros knew other pros and constantly talked with them to find out what was going on in the marketplace. This network was an important edge for many of the traders.

To illustrate that point, check out this excerpt of an interview with Ken Heebner in Fortune magazine:

When we discussed copper last fall, you clearly knew a lot more about the supply outlook than most commodity analysts. Copper production is water-intensive, and you mentioned water has been in increasingly short supply in some mining regions in Chile. Where do you get such good info?

Even today, no one else is interested in the water issue in Chile. You call the companies up, and they tell you there’s no problem - the reason is, they’re trying to buy water rights and don’t want to lose leverage. So if all you do is talk to management, you’re going to hear there’s no problem. But I talked to a mining engineer from one of the companies, and he started out saying, “We don’t have a water problem, we get 700 liters per second from our mine in the southern part of the country.” But then he mentioned how those guys up north, they get only four or five liters per second. I go, Really? He says, “Yeah they have to go 200 kilometers to get water.” Was it that way two years ago? “No.”

Make sure you read the whole interview because Heebner goes into a lot of different markets and sectors. His take on AMD is also interesting.

And in case you’re wondering why you should pay attention to Heenber, he has delivered 17.2% a year, vs. 12.8% for the S&P 500 index going back over 30 years.

The Bullish Percent for a sector or index is created by counting the number of stocks within the sector or index that are currently trading with a point and figure buy signal and dividing this by the total number of stocks in that sector or index.

Overbought levels are at 70% and above, while oversold levels are at 30% or below. A signal is given when the BP index trades through these levels and then reverses by atleast 6%. This almost happened within the energy sector today when its BP index rose 5.56% points from its low of 22.5% yesterday.

You might have to squint to see it below but there really is a tiny uptick in the energy BP index from a very deep oversold level. If we go by recent market behaviour, this means we have put in a significant intermediate bottom.