Cautious Traders Rarely Break to New Highs

State Street Global Advisors – the firm that created the first U.S.-listed exchange-traded fund (ETF) back in 1993 and the SPDR ETF family – manages a portfolio of the following 11 sector-based ETFs:

• Industrial Select Sector SPDR Fund (XLI)
• Consumer Discretionary Select Sector SPDR Fund (XLY)
• Energy Select Sector SPDR Fund (XLE)
• Technology Select Sector SPDR Fund (XLK)
• Communication Services Select Sector SPDR Fund (XLC)
• Financial Select Sector SPDR Fund (XLF)
• Consumer Staples Select Sector SPDR Fund (XLP)
• Materials Select Sector SPDR Fund (XLB)
• Utilities Select Sector SPDR Fund (XLU)
• Health Care Select Sector SPDR Fund (XLV)
• Real Estate Select Sector SPDR Fund (XLRE)

Sector-based ETFs have become incredibly popular among both individual and professional traders because of their low fees and the instant diversification they provide. While I appreciate these ETFs – as well as the sector-based funds that are managed by iShares, Vanguard and others – for the potential portfolio assets that they are, I also like them because they give me an easy way to monitor what is happening within the stock market.

Identifying which sectors are doing well, and which sectors aren’t, provides insights into trader sentiment and where the market may be going in the future. This form of intra-market analysis is often called sector-rotation analysis.

For instance, when the financial, technology, industrial and consumer discretionary sectors are outperforming the other sectors, it is usually a sign that trader sentiment is bullish and the underlying economy is doing well. Conversely, when the utilities, health care, real estate and consumer staples sectors are outperforming, it is typically a sign that trader sentiment is faltering and the underlying economy is not doing as well.

Any guesses which sectors are outperforming at the moment? If you look at the charts of all 11 Select Sector SPDR Funds, you will only find two that are trading above their respective 2018 highs: XLU and XLRE. Both sectors have been allowed to flourish during the past two quarters as the 10-year Treasury Yield (TNX) has dropped and remained below 3%, making the dividend yields of the stocks in these two sectors more competitive by comparison.

However, it appears that the move into utilities stocks, in particular, has been driven by much more than a mere search for strong dividend yields. Traders seem to be shifting away from more aggressive, risky stocks and into more conservative, defensive stocks. Utilities stocks have long been considered defensive holdings because of both their stable dividends and their stable business model, even during economic downturns. While most consumers will pull back on discretionary spending during a recession, almost all consumers will continue to pay their utility bills.

This shift indicates that traders still want to maintain equity exposure in their portfolios, but they want to be more cautious in their approach. Seeing this, I’m inclined to think the S&P 500 and other major stock indexes are going to continue encountering resistance as they attempt to climb back up to their 2018 highs.

The S&P 500 started off the week with a bang, but today’s gravestone doji may signal the end of the bounce. Gravestone dojis typically signal the end of a bullish run as traders attempt to push prices higher but are unable to hold onto those lofty levels and end up giving back most of their gains on the day.

If that is the case, and the short-term bullish bounce is over, the S&P 500 will have failed to reach 2,800 (red box) after having reached that level once in late February and again in early March (green boxes).

I point this out because we’ve seen this pattern before. The S&P 500 bounced and hit resistance at 2,800 in mid-October 2018 and again in early November 2018 (green boxes) before bouncing and failing to reach 2,800 in early December 2018 (red box).

We all know what happened to the S&P 500 after the index failed to climb back up to 2,800 last year. Now, I’m not saying the S&P 500 is doomed to drop back down to its Dec. 26, 2018, low of 2,346.58. In fact, there is a significant difference between the pattern we’re seeing in 2019 compared to the pattern we saw in 2018.

The pattern that is developing now is much tighter. Whereas the S&P 500 swung between support at 2,630 and resistance at 2,800 in 2018, the index has only dropped to 2,720 before finding support in 2019. This tells me that, even if the S&P 500 were to pull back after the lower high it established today, it will likely not drop as far. Looking at the chart, 2,630 still appears to be a formidable support level in the short term.

Another indicator I like to watch to determine how confident traders are about the near-term future of the stock market is the relative-strength chart between the Russell 2000 (RUT) and the S&P 500 (SPX).

Small-cap stocks, like those that make up the RUT, tend to outperform when traders are confident and willing to take on more risk in the hope of achieving a greater return. On the other hand, large-cap stocks, like those that make up the SPX, tend to outperform when traders are less confident and aren’t willing to take on as much risk. The RUT/SPX relative strength chart highlights these shifts in sentiment by moving higher when small-cap stocks are outperforming and moving lower when large-cap stocks are outperforming.

After surging higher in early 2019, the RUT/SPX chart has dropped back down to retest the downtrending price level that was serving as resistance on the chart from early October 2018 until Feb. 11, 2019. If this level can hold as a new support level, it will show that traders are still confident heading into the final stretch of Q1 2019, and the S&P 500 may have a chance of breaking above 2,800. However, if the RUT/SPX breaks down through this level, watch for the S&P 500 to languish below 2,800 for the foreseeable future.

Whether we’re looking at the performance of utilities stocks or small-cap stocks, the current message is the same: traders still want to buy stocks, but they are becoming increasingly cautious in their approach.

This isn’t necessarily a bad thing. A prolonged consolidation range for the S&P 500 isn’t the worst thing that could happen on Wall Street. But if sentiment doesn’t become more bullish, the S&P 500 isn’t likely to challenge its 2018 all-time high.

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