Trader’s Narrative

You’ve probably already noticed this since the pattern completed in late July and early August. In case you haven’t, the Philadelphia Banking index (BKX) has carved out a fairly decent reverse head and shoulder formation:

Of course, the technical pattern in the above chart mirrors the one visible in other sectors as well as the general S&P 500 index itself. No surprise there since most stocks take their cue from the major index, rising and falling like the tide.

The one fly in the ointment is the left shoulder (see red exclamation mark on chart). Although the left shoulder is fully formed, I’d prefer to see a more symmetrical one to the right shoulder. That would have only been possible if the year end rally would have taken the Banking index a bit higher to reach the neckline. So it isn’t a picture perfect inverse head and shoulder pattern.

Back in June I mentioned that the financial sector was losing relative strength and the baton had been passed to the Semiconductor Index (SOX). Since then the banks have continued to lag the S&P 500 and the tech sector has been the engine of the stock market.

We’ve got considerable resistance ahead at the 50 level (on the BKX). But the measured move target is 74 - which takes us to the next significant support/resistance level. Needless to say, the reverse head and shoulder formation is the quintessential reversal pattern in technical analysis.

The semiconductor index (SOX) is a high beta sector which can be a leading indicator of the health of the market. It found a floor in late November of last year, much earlier than the S&P 500 index. From there it continued to power ahead with consistently better relative strength:

But in August, while the general market powered ahead, the semiconductors started to lag. That by itself wouldn’t be a major negative for the market. After all, there are naturally short periods of time when the SOX gives up leadership. What stood out at that time was that the trend line starting from November’s bottom and stretching for months and months had been broken.

I wasn’t the only one who noticed. Dave, a reader, contacted me then:

I just realized yesterday that my canary-in-the-coal mines, my lead husky SOX is out-of-sync with SMH, XSD, PSI, IGW, & USD, vis-a-vis their June highs.

Again, by itself, that wouldn’t ring any alarm bells. But considering everything else that we’ve covered which paints a picture of a market dangerously overextended, this just adds to the many other reasons to be positioned for a correction.

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?

While the general market, tracked by large indices like the S&P 500 (SPX), fell to lower levels than late last year, there are pockets of strength in some sectors. One sector that is showing surprising strength is the seminconductors:

Not only has it put in a higher low, it is close to breaking out in its relative strength chart (compared to the S&P 500) - not to be confused with RSI. As well, the 50 day moving average is flat, with prices well above it. The only downside is that the longer term, 200 day moving average, is still barreling down at a good clip and about to smack it around the 255-260 price level. Also, according to the internal measures of the sector, it is just too extended.

Here’s a closer look at the breadth within the Philadelphia Semiconductor Index (SOX):

Notice the cluster of data points where 90% of stocks in the sector have closed above their 10 day moving average. Not only is this very rare, it is unsustainable. Especially as the general market is similarly over extended and catching its breath. While things look much better here, as prices levitate out of the abyss and extend up and away, it isn’t a good idea from a risk/reward view to start buying here. This is where the smart money starts to unload the positions they built during the darkest hours.

There are a few other sectors in a similar technical position. For example, take a look at the AMEX Broker Dealer Index (XBD). From an optimists perspective, all of this points to a gradual rebuilding of the market - not a new bull market! But when the generals that lead the charge are tired, it is time for a pause. From a pessimists perspective, the bear market rally has exhausted itself and the brutal reality of a continuing bear market is about to reassert itself.

There was a chart request for the Philadelphia Semiconductors Index, otherwise known as the SOX.

The analysis is simple, but perhaps not too satisfying. This stalwart of the tech sector has been stuck in a meandering channel for more than five years.

The upper range is ~550 (resistance) and the lower range is ~360 (support) - where the index is now. During the wicked bear market of 2002 (and the early part of 2003) the SOX penetrated the lower range temporarily.

The bear market panic low, near 200, revisited a level previously reached during the 1998 LTCM/Asian currency crisis low. If the channel support doesn’t hold, this is where we would be headed, ultimately.

But while the sideways channel may give us a picture of a sector that is treading water, a relative graph shows that this sector has been a consistent loser:

Semiconductors roared out of the bear market lows of 2003 leading the general stock market higher. But while other sectors went on to a continued cyclical bull market lasting multiple years, the SOX’s rally petered out in 2004.

Since then, they have never really taken the lead and instead have reached relative lows approaching those of 1998.

While value investors may be attracted to the valuation of semiconductor stocks, I would stay away from this sector until it can show that it has either broken down (offering shorting opportunities) or until it eventually builds a base out of all this sideways action and once again is ready to resume leadership of the market.