Telltale Signs of Sector Rotation

Sentiment and fundamentals are often late in predicting turns in a sector, writes Tom Aspray, but using the boom and bust cycle in the homebuilders, he identifies technical signals that can be used to get in and out ahead of the crowd.

Sector analysis has always been a key part of my stock selection process, and I have spent quite a bit of time studying sector patterns and developing technical tools that can help identify when to get in a sector and when to get out.

There seem to be some common phases that sectors go through regardless of whether you are looking at long- or short-term trends. Being able to identify these phases can add clarity and objectivity to your analysis.

While the rise and fall of the homebuilding sector in the past ten years was clearly extreme, the stages that sector went through are commonly found during periods of sector rotation that may only last six months or a year.

Though the sectors typically go through a normal supply/demand cycle, there is often a common series of swings in market sentiment that can help shed light on a sector's price pattern.

The Dow Jones Home Construction Index traded as low as 183 in September 2001 before starting its dramatic run to a high of 1120 in July of 2005. This was a gain of 512% in four years.

Click to Enlarge

The weekly relative performance, or RS analysis, was in a solid uptrend from 2002, line c. During the minor corrections in the uptrend, the RS line dropped below its weighted moving average (WMA), but never started a pattern of lower highs and lower lows.

See also: Spot Leaders and Losers with RS Analysis

The RS line did confirm the index high in 2005 before reversing course. The decline from the highs held support in the 807 area. This was above the lows made in early 2006, line a.

The rally into early 2006 failed at 1039, which was well below the prior highs. This raised the possibility that a head-and-shoulders top could be forming.

As the index dropped to test the key weekly support at line a, the RS line was acting much weaker. In early March 2006 (line 1), the RS line broke its uptrend, line c, and then began a new downtrend. This indicated that the homebuilding stocks were no longer outperforming the S&P 500.

The index bounced for five weeks and the RS line just rebounded back to its now-declining weighted moving average (WMA). The neckline was violated the week ending April 26, and in May, I published a chart identifying the completion of the head-and shoulders (H&S) top.

The downside target from the formation was in the 500-520 area, but I did not dream at the time that the index would eventually drop as low as 162.

By July 2006, the index had dropped to 562, line b, which was a drop of almost 50%. The ensuing rebound took the index back to the 790 level, which just slightly exceeded the 38.2% Fibonacci retracement resistance from the 2005 high.

This rally was accompanied by bullish forecasts from many analysts, and one noted fund manager said in July 2006, "The homebuilding industry will come out of this in decent shape." Another value manager that owned a couple of homebuilders stated "Homebuilders are definitely getting interesting as far as valuation goes."

This type of press is typical of what occurs during corrections in major trends. In bull markets, there is often a spate of bad news that turns many negative on the sector just as it undergoes a normal correction.

In bear markets, we often see sharp rallies that take the shape of bear flags. They are often accompanied by a spate of new buy recommendations because the fundamental data or valuations make them seem attractive.

Just this spring, the bullish sentiment on the tech sector reached a fever pitch following earnings from Apple, Inc. (AAPL). Now that the tech sector has corrected sharply, I was not surprised to see a Bloomberg headline this week that read, 'Is the Tech Boom Over?"

As the homebuilders were rallying in 2006, the RS line stayed weak, identifying overall weakness in the homebuilding sector. The drop in the index below the long-term support at line b coincided with the news that Bear Stearns was going to have to bailout two of its hedge funds.

By mid-July 2007, it was disclosed that these hedge funds had lost almost all of their value due to subprime mortgage losses. The RS line stayed in its well-defined downtrend into 2008, indicating that it was a sector to avoid.

NEXT: Volume Signal That Identified Homebuilders' Boom and Bust Cycles

The volume analysis of the Dow Jones Home Construction Index did pretty good job of catching both the uptrend and downtrend in the homebuilding stocks. Here, I will concentrate on the rally from the 2004 lows through the 2005 highs and the ensuing decline. I also wanted to note the typical continuation patterns (in green) that formed in 2003 and 2004.

As I discussed in a past Trading Lesson, continuation patterns are one of my favorite investing and trading set-ups. They often take the shape of a triangle or flag and generally last just long enough to cause many to change their outlook.

Click to Enlarge

The correction in 2004 lasted six months while the index dropped 20% from its highs. This was enough to cause some to wonder if the homebuilders had topped out, and I'm sure many sold out just before the homebuilding stocks accelerated to the upside.

The on-balance volume (OBV) moved back above its weighted moving average in August 2004 (line 1), confirming the completion of the flag formation. The OBV stayed above its weighted moving average until September 3, 2005 (line 2). Two weeks later, the uptrend, line a, was decisively broken and the volume was the heaviest it had been in several years (see arrow).

See also: OBV: Perfect Indicator for All Markets

In early-January 2006, the OBV rallied back to its declining weighted moving average and then started a new downtrend. The volume was heavy again from April through July that year, as the OBV was now leading prices on the downside.

The OBV moved above its weighted moving average on the rally in late 2006 and the index formed a nice flag formation (dashed lines). Volume declined as the index moved higher (see arrow) and then increased as the continuation pattern was completed. The OBV stayed below its downtrend.

In mid-July 2007, volume was very high as the first subprime mortgage problems surfaced, but by early fall when the stock market stabilized, some advisors were recommending homebuilders, as the New York Times quote on the above chart indicates.

Another flag formation formed in late 2007 and early 2008, but once again, it was an opportunity to sell homebuilding stocks. The OBV stayed below its long-term downtrend, (line b) during this period and made lower lows into early 2009.

It has been my experience that technically, a stock will generally top out ahead of the fundamentals. I have seen many stocks turn lower while the earnings are still improving. They will often stay positive for another quarter or two before they start to weaken, but by this time, the stock is generally well below its highs.

NEXT: One of the Most Dramatic Homebuilder Charts of All

Ever since the early 1980s, I have analyzed fundamental data from a technical standpoint. Therefore, in looking for long-term fundamental data on the housing industry, I found this chart of the Wells Fargo Housing Market Index and new single family housing starts quite interesting.

The Housing Market Index (HMI, in blue) is a measure of sentiment that reflects builder confidence in the market for newly built, single-family homes. In early 2006, the HMI formed a lower high than in 1999, line a, which was negative because the number of new single family starts (in red) was still forming higher highs.

Click to Enlarge

The uptrend in the HMI, line b, was broken in March 2005, which coincided very nicely with the completion of the H&S top in the Dow Jones Home Construction Index. The HMI now appears to have completed a short-term bottom formation, as the higher lows, line d, were followed by a move above the resistance at line c. The HMI has a long way to go before it gets back to the 50 level, but this is still an encouraging sign.

The below monthly chart of the Dow Jones Home Construction Index shows that it made its lows in early 2009 at 130, and last October, it made a higher low at 164.93, line c. The monthly downtrend, line b, was broken at the end of January 2012.

Click to Enlarge

The index made a high in May of 350.51, which exceeded the April 2010 high at 333.85. Therefore, a new uptrend in the index had begun, as discussed in this recent Trading Lesson. More important resistance now stands at 426 with the major 38.2% Fibonacci retracement resistance at 510.

The monthly OBV bottomed in 2006 and then formed higher lows in 2007, 2008, and 2009, line e. This long-term bullish divergence indicated that the long period of liquidation was likely over.

In January, the monthly OBV moved above its weighted moving average, and more importantly, it overcame the long-term downtrend, line d. This confirmed the positive divergence. Weekly OBV (not shown) also formed a bullish divergence at the October lows, which was confirmed in December.

The weekly chart (right panel) of the very liquid SPDR S&P Homebuilders ETF (XHB) shows the sharp rally from the low at $12.21 in early October and the high of $21.94 in late April.

The weekly RS line formed higher lows in October and crossed above its weighted moving average by the middle of the month. The relative performance has weakened over the past few weeks, as the RS line has dropped below its weighted moving average and violated its uptrend, line g.

Weekly OBV also formed a positive divergence at the October lows and then overcame 18-month resistance in early 2012, line h. The OBV formed lower highs in March, line i, and was even lower when XHB was making its high at the end of April. The OBV has broken its uptrend but has not yet started a clear downtrend.

Last week, XHB traded as low as $18.93 with the 38.2% Fibonacci retracement support at $18.54. The more important 50% support stands at $17.33, which represents a more important zone of support. The daily technical studies are negative, but since the correction has already lasted almost six weeks, the majority of the decline may be over.

There were clear technical signs last October that the homebuilding sector had bottomed. By February of this year, the fundamental data had improved to the point where the number of bullish articles on homebuilding stocks had increased significantly. As I result, I started to take profits on some of the homebuilding stocks I recommended and tightened the stops on remaining positions.

Since XHB topped out, the headlines have become much less positive. This change in sentiment became more evident in early June when homebuilding stocks plunged following the US unemployment report.

NEXT: Latest Outlook for Top Homebuilding Stock PulteGroup (PHM)

As for individual homebuilding stocks, PulteGroup Inc. (PHM) is one in particular with which we have had good success in the past. The monthly chart shows that PHM made lower lows in October, line b, but then rallied above the strong resistance in the $8.40 area.

Once above the May 5th high of $10.82, the next major resistance is in the $13.90 area. The major 38.2% Fibonacci retracement resistance from the 2005 high of $48.32 is at $20.50.

Click to Enlarge

The three-year downtrend in the monthly relative performance, line c, was broken in April. The monthly OBV formed a long-term bullish divergence at the October lows, line e, which was confirmed by the move through major resistance at line d. This is consistent with a major low.

The weekly chart of PHM shows that it peaked at $10.82 and has since traded as low at $7.62. The 50% retracement support is at $7.11 with the 61.8% support at $6.31. The RS line was able to overcome resistance at line f and is still holding above this support.

The volume in early 2012 was very heavy, as the OBV surged well above resistance at line h. The OBV formed a negative divergence at the April highs, line g, and has since dropped below its weighted moving average. A move through this resistance (line g) would be a sign that the correction is over.

Over the next few weeks, I would not be surprised to see more negative sentiment on the homebuilding sector, but technically, this is the time when these stocks could be completing their corrections.

Hopefully this discussion of the homebuilding sector will encourage you to not be overly influenced by the sentiment of the financial media. By using a combination of relative performance analysis and on-balance volume, you should be better able to identify when a sector has become a market leader.

Once you take a position in a sector ETF or in a strong stock from a market-leading sector, identify the key upside targets using a combination of chart and Fibonacci analysis. Once the first target is reached, you need to become even more vigilant in looking for signs that the trend is maturing.

If you start to see signs of technical weakness, keep an eye on the financial media to see if the sector is becoming too popular. If you are fortunate to take some nice profits before the correction becomes serious, continue to monitor the sector for a new entry point. It is often the case that the second rally phase in a sector is more dramatic that the first. As such, I will be looking for a new opportunity in the homebuilders in the coming weeks.