A very basic but time-proven way to measure risk appetite in equity markets is to follow the performance of cyclical versus non-cyclical market sectors.  During times of better performing economies the so called cyclically sensitive sectors tend to outperform.  Stocks such as Caterpillar (CAT) in the industrial sector or Dick’s Sporting Goods (DKS) in the consumer discretionary sector shine during such times as more construction demand and discretionary income helps such companies.  On the other hand a weaker economy will favor stocks such as utilities and household non-cyclicals because consumers still need to eat, heat their homes and keep them clean and sanitary.

Of the ten sectors in the S&P 500, three of them are decisively non-cyclical, or also known as ‘defensive;’ Utilities, Healthcare, Consumer-Staples

From a technical point of view, out of the three non-cyclical sectors I particularly focus on the utility sector as it trades in relation to the more cyclical sectors.  The specific security as a proxy for the utility sector that I like to analyze is the Utilities Select Sector SPDR ETF (XLU).  This etf contains some of the largest utility names in the United States such as Duke Energy Corp (DUK) and Southern Co (SO).

At first look from a longer-term perspective of four years the sector looks just fine as it remains in the up-trend that was confirmed in 2010.

However, warning signs that the utility sector was in trouble arose in August, which simultaneously gave a much more constructive buy signal for the broader equity market.  With the continued strength in broader equities during the month of August, defensive sectors and in particular the utilities started to weaken and the XLU broke its up-trend that had been in place since 2011.  In mid-October, this time much in -line with the broader market,  the XLU made another run higher and re-tested the 2011 up-trend, before eventually falling hard also along with the broader market and cyclical stocks.

While the utilities sector as represented here by the Utilities Select Sector SPDR ETF (XLU) fell along with the broader stock market in late October and early November, what is striking is the relative under-performance of utilities.  Most cyclical sectors remain in a fairly healthy consolidation phase, except for utilities, which look to have reversed course.

A closer look at the Utilities Select Sector SPDR ETF (XLU) shows the lower high that developed in October and eventually led to the sharp sell-off.  From an even more technical angle note that the lower high corresponded with the 61.80% Fibonacci retracement of the July highs to September lows swing.  The etf then went on to hit the 23.80% Fibonacci extension target, and while doing so also violently broke through its 200 day simple moving average (red line).

The above analysis leads me to view the current correction in broader U.S. equities and the S&P 500 as a healthy one that should soon lead to stabilization of the down-move and to a rally into year-end.  My call is not necessarily to short the Utilities Select Sector SPDR ETF (XLU) but rather to play the relative out-performance of the more cyclical sectors such as financials, materials, industrials and some technology.

 

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