Trader’s Narrative

Here are two free online tools that analyse the relationship between stocks and help you to find correlated stocks (or negatively correlated stocks):

Select Sector SPDR Correlation Tracker

Any quantjock worth his salt will laugh at such a simplistic treatment of correlation but for the rest of us it is a useful tool. How useful is it and why would you want that kind of information in the first place?

Knowing the correlation of one stock to another helps you in define your portfolio. After all, what good is owning separate stocks or even ETFs if most of them are correlated? If you don’t diversifying your holdings you are at risk that a market shock will effect them all at once and in the same way.

Another reason to look for correlated stocks is to engage in pair trading. This is where you aren’t interested in a stock per se but the relationship between two stocks. There are different strategies but the simplest is to watch the relationship and when it gets out of historical norms, to go long one and short the other.

Another online resource is Market Topology, now renamed: Impactopia.

They offer more robust analysis with a choice of time frames as well as the ability to graph the spread of two stocks or each, side by side. To use the site you may find it asks you to sign up but the service is free.

Impactopia has other goodies if you explore enough. For example, it plots a “tree” of the security you are curious about mapping out its relationship with other securities. You can see Google’s (GOOG) tree to above.

If you think the financial sector has been roughed up, check out a long term chart for the homebuilders. They’ve gotten crushed.

Although it is always most difficult, it is rewarding to step in and buy when no one else is. Right now sentiment and the technicals have reached a crescendo of pessimism that usually signals an inflection point.

Take a look at the chart to the left. It is a survey from the National Association of Home Builders (NAHB) showing that only 28% of them see the housing market as “good or fair”. To put it in perspective, this is the lowest reading in 16 years. Very gloomy. Very doomy. Wouldn’t you say?

And there’s more. An economist with Moody’s economy.com wrote recently, “The bottom of the housing market appears nowhere in sight”. Ouch.

If we look at the sector using the SPDR S&P Homebuilders (XHB) ETF, we get an idea of the carnage in this sector. Right now, there are zero stocks in this sector above their 10 day moving average. A paltry 5% above their 50 day moving average and only 24% above their long term, 200 day moving average. That is extremely oversold on all time frames.

Now, I know things are really ugly out there. Not only on the charts, but also with fundamental factors like foreclosures, ebbing liquidity, stricter lending practices, unsold home inventories, etc. But technical analysis attempts to look over what is happening right now, to what is coming.

So I’m not trying to be a pollyanna when I say that this sector merits attention. I acknowledge all of this and because of the confluence of it and the technical and sentiment picture, I think there’s an opportunity.

Here’s another data point to throw into the pot. The short interest ratio of this sector is 5.3 or 15.4 million shares. That’s come down from last month but still provides a contrarian support to my thesis since shorts provide a bid below price and above price, their stop losses creates momentum to the upside. Of course, this has to be taken with a salt mine since a lot of traders use the ETF to hedge otherwise long positions in the sector (long home building stock & short sector or other exotic combos).

In any case, the price action of the sector ETF (XHB) as well as the individual components is key. Yesterday both showed a decidedly bullish move. Many an engulfing bullish candle was formed as buyers finally came in and pushed homebuilders up for a change. The fact that there was volume behind the price action gives even more impetus for a bullish stance.

Take a look at Beazer Homes (BZH). It is right at pivot support around $28:

I’d be looking for similar bullish setups in the homebuilding stocks. Another example is WCI Communities (WCI) which formed a hammer on high volume after a protracted and sharp decline. And finally, take a look at Centex (CTX) as it found support at $40 - its 2004 summer low.

A reader (Pat) got in touch with me today to point out that there was something rather peculiar in the trading volumes of UltraShort S&P 500 ProShares (SDS) and the Ultra S&P 500 ProShares (SSO). If you’re not familiar with them, these are relatively new ETFs.

According to their prospecti, SDS and SSO seek daily investment results, before fees and expenses, that correspond to twice (200%) the daily performance of the S&P 500 Index.

As the name suggest, the UltraShort (SDS) ETF offers twice the inverse of the S&P 500. So when the S&P 500 goes up, it will go down twice the amount. While the Ultra (SSO) provides a leveraged bet (twice) on the index going the same way.

Although easy to ignore, since these are usually used as trading vehicles not investment vehicles, the expenses are surprisingly high at 0.95%. To compare, the SPDR S&P 500 ETF (SPY) only charges an MER of 0.0945%, or less than a tenth.

In any case, the level of activity in both ETF was very low until just at the end of February 2007, when we had the infamous Chinese mini-crash. After that, both ETF volumes perked up. But the UltraShort S&P 500 ProShares (SDS) volume increased much more. So Pat was wondering if this meant something in terms of sentiment.

Why is the trading volume of SDS (short ETF) almost 10 times more than SSO (long ETF)?

I really don’t know, but if I had to take a guess, I would say that people got really spooked when the market fell earlier this year. And maybe they suddenly discovered this new way to have exposure to the short side.

Many traders and investors who have cash accounts are not able to have short positions. But with this ETF, by going long (buying) they are in fact exposed to the short side. Almost makes your head hurt to think about it

I don’t think we can muster any sort of sentiment significance for this lopsided volume though. I consulted with a much wiser technical analyst (Jason Goepfert of Sentimentrader.com) and he agrees. He further added that instead of looking at the volume, track the assets that are in each ETF.

That way, you can get a glimpse into whether people are piling into the long or short side. And use that as a contrarian signal. This is similar, by the way, to how the Rydex Funds have been used for many years. The difference being that they are mutual funds and not ETFs.

Before I delve into the current state of the utilities sector, allow me to do some accountability and revisit my last post: Deceptive Relative Strength in Utilities. That was at the end of July 2006 and the best that my bearish call on the sector did was see it trade flat for the next two months. To be fair, I didn’t call for a short outright but still, after that pause the utilities continued up and rose 27% (just before a tumble last week). I’d give that call a C+. But I’m biased

So how about right now?

Well lets take a look at the technical picture of the sector (as defined by the Utilities Select SPDR: XLU):

• 3.33% above 10 day moving average
• 20% above 50 day moving average
• 83% above 200 day moving average
• all time high volume on Thursday (May 24th 2007) 14.9 million shares
• bullish percent (of S&P Utilities Sector Index) very high at 94%

According to this Lowry’s breadth study, when 10% or less stocks are above their 10 day moving average, it is a reliable indicator of a deeply oversold market. While this study was for the general market, I think it is safe to make inferences for sectors as well. Right now we are seeing an unheard of 3% of utilities stocks above their 10 day moving averages. If you look at no other indicator, this by itself should be flashing a red light warning of a snap back rally.

The other percentage above moving averages are showing an oversold market on the medium term (50 day moving average) but long term (200 day moving average and bullish percent), the sector is in a robust bull market. Finally the spike in volume for the sector ETF can be interpreted two ways: there is a lot of emotion as people panic and dump their shares, and two, people are fleeing the danger of individual stocks (higher risk) for the relative safety of an ETF (basket of stocks).

Putting all this together, I think we are about to see a technical snap back in the utilities sector. I’m putting the really oversold ones on my watchlist for this week. They may even present good intraday opportunities.

Some suggest that the message of the market in the sudden decline of the sector is that the Fed is going to raise rates. I don’t read that much into it. The sector was obviously overbought and needed to pull back. Just look at its distance from its long term moving average (200 day). I actually wouldn’t be surprised by a rate cut - but then again, what do I know?

Here are the components of the Utilities Select SPDR (XLU) in order of index weight:

Exelon Corp. (EXC)
TXU Corp. (TXU)
Dominion Resources Inc. (D)
Southern Co. (SO)
FPL Group Inc. (FPL)
Duke Energy Corp. (DUK)
Entergy Corp. (ETR)
FirstEnergy Corp. (FE)
Public Service Enterprise Group Inc. (PEG)
American Electric Power Co. Inc. (AEP)
Edison International (EIX)
PG&E Corp. (PCG)
PPL Corp. (PPL)
Sempra Energy (SRE)
Constellation Energy Group Inc. (CEG)
AES Corp. (AES)
Progress Energy Inc. (PGN)
Consolidated Edison Inc. (ED)
Ameren Corp. (AEE)
Xcel Energy Inc. (XEL)
DTE Energy Co. (DTE)
Questar Corp. (STR)
Allegheny Energy Inc. (AYE)
KeySpan Corp. (KSE)
NiSource Inc. (NI)
CenterPoint Energy Inc. (CNP)
Pinnacle West Capital Corp. (PNW)
Integrys Energy Group Inc. (TEG)
CMS Energy Corp. (CMS)
Dynegy Inc. Cl A (DYN)
Teco Energy Inc. (TE)
Nicor Inc. (GAS)