Trader’s Narrative

Towards the end of May I wrote about the utility sector being oversold, the next day it had a snap back technical rally. Here’s an update on the sector.

If it wasn’t clear, I wanted to emphasize that there is a difference between a technically oversold, short-term snap back rally and a deep oversold condition which results after a prolonged and steep decline. The former can be only caught by nimble traders while the latter by position traders who want to catch intermediate moves.

Looking at the technical picture of the Utilities Select SPDR (XLU), I don’t think we are seeing any sort of intermediate bottom - atleast not the kind we’ve seen before. The bullish percent moved sharply lower from 96.25% to 83.33%. It only goes to show how strong this sector is that such a decline leaves it still at a historically high bullish percent reading.

The last intermediate bottom in this sector was in last summer when the BP reached a low of 67%. Historically, we’ve seen much, much lower BP readings form bottoms. In September 2001, there was a BP reading of 23.26%, in July 2002, 13.33% and October 2002, 20%. In keeping with the characterstic of strong bull markets, we have been able to launch further up moves from shallow oversold.

Looking at the percentage of stocks in the sector above their moving averages:

• 57% are above their 200 day MA - a real washed out would be around 20%
• 10% are above 50 day MA - lower than the 20% reading last summer
• only 1 utility stock is above its 10 day MA

So basically, in the short term, the utilities sector is stretched into oversold territory. But by any longer term measure, things are not as extreme. If you’re a nimble trader, you can catch short term moves but as a position trader or longer term investor, eventhough it is off its highs, I don’t think this is the time to add fresh money to this sector.

Yesterday I wrote about utility stocks being on sale. Today most of them gapped up in a technical snap back but finished the day poorly.

Still for nimble traders there was ample opportunity to take advantage of the short term oversold condition in this sector. Here are two charts from FPL Group (FPL) and Entergy (ETR) which are representative of what happened in this sector today:

We still have quite a ways to go to fully work out this oversold condition. Eventhough it won’t be straight up to new highs, this sector bears watching. Especially the high prices stocks which present good low risk opportunities when they contract in range and volatility.

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)

Utilities have been among the few sectors with high relative strength during this recent swoon that began in May. Even Chairman MaoXian recently made note of this. Usually this would make me like the sector because by swimming upstream against the current, it is showing that the ’smart’ money has spoken. But there is more to it when you look beneath the surface.

For one, the breadth in the sector makes the probability of a continued rally very low. Right now, 100% of the constituents of the utilities ETF (XLU) are trading above their 50 day moving average; as well, more than 90% of them are trading above their 200 day moving average. Much like a sprinter after a mad dash, the sector is out of breath having exhausted itself in this recent run up. The best thing that we can hope for is a pause. A fall from these heights is also possible since the sector is up to an old resistance that has pushed it back since August of 2005.

Another reason why I’m suspicious of the sector’s relative strength is that it is not the ’smart’ money that has been buying utilities. Looking to the Rydex utilities sector fund, its assets have swelled from a paltry $10 million from just a few months ago to almost $100 million today. Obviously the retail, Mom’n'Pop investors are crowding into this sector like crazy. Maybe their rational is to take refuge into ’safe’ stocks, maybe they are mo-mo investors who are simply buying because it has gone up, maybe they think the interest rate cycle has peaked… who knows.

All I know is that they are the crowd to fade not emulate. In fact, the last time the Rydex crowd got this excited about the utilities sector fund was back in July 2005 (first red circle). The other times were September 2000 and February 2001. Both great long to intermediate sell signals.

Although I don’t think the utilities are an automatic short here, if you’ve got any, it is prudent to look for exits and tighten stops. This would be especially wise considering that the sector and almost all of the individual stocks within it printed a very bearish wide range dark engulfing candlestick today. This is a very powerful reversal pattern, especially after a significant run up in price as we’ve had in utilities.