Are Utilities Signaling A Higher Stock Market?

08/21/09 10:26:59 AM

by Alan R. Northam

The utilities market sector continues to underperform the Standard & Poor's 500. Does this signal higher prices ahead for the broader stock market?

Security: XLU
Position: N/A

The bull market came to an end in October 2007 and began a bear market selloff that lasted until March 2009, dragging all market sectors down with it. Since the market bottom in March 2009, the stock market has been working its way higher and has established itself in a new bull market uptrend. However, the stock market is now overbought and ready to reverse direction. The question is now whether the next reversal will be corrective in nature, or will it signal the resumption of the October 2007 bear market? To answer this question, all we have to do is to look at the defensive market sectors. When traders and investors become worried about the future of the stock market, they start reducing their stock market positions and increasing their positions in defensive market sectors as they run for cover to reduce risk. By determining the trend of the defensive market sectors, it becomes possible to determine if the broad stock market is simply overbought and ready for a corrective pullback, or if the stock market is topping and the bear market is about to resume.

Figure 1 shows the weekly closing price line chart of one such defensive market sector, the utilities market sector (XLU). This chart shows that from 2007 until early 2009, the utilities market sector has been in a downtrend, making lower highs (LH) and lower lows (LL). From March 2009 to date, the XLU has been working its way higher by making a series of small higher lows (hl) and higher highs (hh), signaling that the utilities are now in an uptrend. However, XLU remains below the November lower high (LH) as measured by the overhead resistance line drawn off the November high. Until this line of resistance has been violated, XLU's series of lower highs and lower lows from the October 2007 market top still has not been broken, and thus, the long-term trend remains downward and the series of smaller higher lows and higher highs since March are simply corrective in nature.

FIGURE 1: XLU, WEEKLY. This figure shows the utilities in a new upward trend but remain below overhead resistance. This chart also shows OBV and the price relative ratio line.

Graphic provided by: StockCharts.com.

On-balance volume (OBV) is an indicator that measures volume by adding up volume and subtracting down volume and the result is an accumulation of volume. When the OBV line is moving higher, it tells us that buyers are in control of the market, and when it is moving downward, sellers are in control. Looking at OBV, we observe that volume has been up against overhead resistance since February 2009. This is a signal that volume is not expanding. One of the characteristics of a bull market is expanding volume. With volume being in a trading range since April 2009, its characteristics are more in line with a market correction than a new bull market.

Below the OBV chart in Figure 1 is the price relative chart. Price relative is derived by dividing the utilities market sector by the S&P 500. When the price relative line is moving upward, it signals that the market sector is outperforming the broader stock market, and when it is moving downward, it is underperforming the broader stock market. Note that in the price relative ratio line, two downsloping trendlines can be drawn. The first trendline is drawn off the mid-November 2008 and mid-January 2009 peaks. The second trendline is drawn off the January 2009 and June 2009 peaks. The second trendline is steeper than the first trendline, signaling that the price relative ratio line has been accelerating in the downward direction during the complete price rally since March. This downtrend signals that the utilities market sector has been underperforming the S&P 500 at an accelerating pace.

While the utilities market sector continues to trend higher, volume is not expanding to keep pace. In addition, the utilities market sector has been underperforming the S&P 500 during the complete rally off the March low. These technical factors are more characteristic of a market correction than a new bull market uptrend. Therefore, there is no reason to expect a broad stock market top at this time and we should expect higher prices ahead.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.