How The Utilities Got Their Groove Back

06/05/06 03:52:57 PM

by David Penn

Intraday positive divergences in the stochastic helped traders in utilities shares find a bottom.

Security: UTH
Position: N/A

When all else fails, go to the playbook. As I have been writing in Working-Money.com's "Sector Spotting" column, speculators and traders have been able to take advantage of turns in the business cycle by looking to buy those stocks in sectors that benefit disproportionately from the economic conditions (or, perhaps more accurately, economic sentiment) that accompanies each turn of the cycle.

FIGURE 1: UTILITIES HOLDRS, HOURLY. High-volume days are always worth watching, no less so here in the case of the bottom in UTH. Note there is one strong accumulation day late in the UTH's decline and another that gapped UTH higher at the open just as the exchange traded fund was nearing a potential source of resistance.

Graphic provided by: Prophet Financial, Inc.

Most obviously, the recent beneficiaries of the economy's current position in the business cycle has been the oil service stocks, as well as the smokestack group of industrial, manufacturing stocks (see my Traders.com Advantage article "Smoke Rising" from November 16, 2005). However, in April, I began to notice strength in a number of consumer staples stocks. While the consensus view was that betting on stocks was merely a weak dollar play, this response—which I received from more than one smart and widely listened to money manager—ignores the fact that it is precisely that moment in the business cycle when inflation is believed to be raging, that the Federal Reserve will be at its most passionate about "cooling the economy," that the dollar will be falling, and that consumer staples stock stand to be rewarded. The behavior of such stocks since I wrote "Counting On Consumers" for Working-Money.com (May 1, 2006) speaks for itself.

So what's on deck? Once the cycle slows down enough for investors to become interested in the "safety" of consumer staples stocks, there really are only a few places to turn. One of those places is the bond market. As Bob Brinker, long-time money manager and host of Bob Brinker's Money Talk radio program once quipped, "If stocks are in trouble, then the place to be isn't a sector. It's in bonds." Another approach is to bet that the contraction phase that brings on an affection for "safe" stocks will be a short one, and it is better to plan for the coming expansion through purchases in the financial and technological sectors.

FIGURE 2: UTILITIES HOLDRS, HOURLY. This positive stochastic divergence in UTH was among the clear signals that the correction in the utilities group was nearing an end.

Graphic provided by: Prophet Financial, Inc.

There is one other destination for investor cash during the early stages of a contraction (with an emphasis on "early," recalling Brinker's admonition). And that destination is the ultimate "safety" stock sector: the utilities group (Figures 1 and 2). Why utilities? Well, if the preference for consumer stocks lies in the notion that, however ill the economy becomes, consumers will still wash their clothes, eat breakfast, smoke cigarettes, and drink beer, then it follows that few economic storms could be difficult enough to encourage people to forgo heating (or cooling, for that matter), or water, or electricity ...

I think the utilities are increasingly the next group to watch. While I've recently written that biotechnology stocks will be a solid tell on whether the market is ready to make a bet that the contraction will be brief (see my forthcoming Working-Money.com article, "Betting On Biotech"), the fortunes of utilities companies will serve investors looking to gauge the effect of any "flight to quality" in the stock market.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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