A Safety-Led Momentum Market | Seeking Alpha

Wall Street can’t seem to shake its bad case of the jitters. This is clearly evident by the inability of the major indices to get a sustainable rally going, as the benchmark S&P 500 Index (SPX) remains stuck in a multi-month trading range. Yet, despite the market’s weakest areas – mainly the energy and healthcare sectors – there are still sufficient reasons for investors to assume a best-case outlook for the fourth quarter. As I’ll show here, there are some key market segments, which, ironically enough, are defensive in nature that will keep the bull market’s forward momentum intact and, ultimately, pull it through this volatile period.

Most of the equity market’s nerve-wracking moments this year have come courtesy of escalated tensions involving the U.S. and China. This week proved no exception as a growing number of stocks on both exchanges fell to new 52-week lows on the news the U.S. Commerce Department had placed 28 additional Chinese companies on its Entity List over human rights abuses. China’s foreign ministry spokesman denied the allegations and suggested that China might leave this week’s trade negotiations with the U.S. early. It was further announced that the U.S. would implement visa restrictions on any of China’s officials with links to human rights abuses.

As we’ve all come to expect, the slightest hint of bad news relating to China has been enough to provoke selling pressure in equities. The 1.60% decline in the SPX on Tuesday was the latest such example of this. The ongoing spat between China and the U.S. can’t be entirely blamed for investors’ erratic behavior, however. As I’ve noted previously, the broad market is most susceptible to the influence of negative news headlines when there is any degree of internal selling pressure below the surface. Even in those instances when the SPX and other major indices are at or near all-time highs, if even a couple of major sectors or handful of industries are subject to liquidation pressures, it can spill over into the rest of the market. News which investors perceive as bad is thus used as an excuse to unload more of the stocks in the areas already undergoing distribution (i.e. informed selling).

In the present market environment, it’s the Nasdaq which has shown the most pronounced selling pressure in the last several weeks. This sub-surface weakness has manifested mainly in the areas of pharmaceutical and biotech stocks being sold and making new 52-week lows. On most days since last month, the number of Nasdaq-listed stocks making new lows have been well above 40. This is a sign of above-normal weakness, and the weakness in the aforementioned healthcare sector seems to be intensifying.

On Oct. 8, for instance, there were 132 new lows against only 19 new highs. That the Nasdaq new lows are in the triple digits is completely unacceptable; it’s even worse that the tech sector is showing a negative high-low polarity. Below is a graph that illustrates the rising number of new 52-week lows on the Nasdaq. Until the new lows shrink to fewer than 40 for a few consecutive days, my recommendation is for traders to avoid taking on new commitments in Nasdaq stocks, tighten protective stops, and also to prune laggards among existing holdings.

Source: StockCharts

Meanwhile, on the Big Board, the high-low differential has been mostly positive recently, though not by much. There were 77 new highs on the NYSE versus 35 new lows. It’s also disturbing on an immediate-term (1-4 week) basis that the new 52-week lows on the NYSE have tended to rise above 40 whenever a negative China-related headline crosses the news wires. That was the case on Oct. 8 when the new lows rose to 94. Most of the NYSE new lows continue to be in the energy sector, an area that should also be avoided for now by prudent investors. The new 52-week highs, meanwhile, continue to be dominated by real estate equities and to some extent, utilities. Ironically, real estate and utility stocks – which are normally treated as safe havens by investors when interest rates are low – are keeping the bull market intact right now.

Shown here is the year-to-date performance of the Dow Jones Utility Average (DJUA), which recently hit an all-time high. It’s worth noting that whenever the DJUA is significantly outperforming the SPX – as it is now going – the broad market’s intermediate-term (3-6 month) outlook can be assumed to be bullish. Historically, when informed investors see danger ahead for the intermediate-term outlook, they’ve liquidated their holdings in the utility stocks along with stocks in other major sectors (e.g. in 2015). When the DJUA fails to make a new high within a year’s time, for example, it often serves as an advance warning for trouble ahead in the broader equity market, much as it did before last year’s selling panic.

Yet, with utility stocks actually among the market’s top performers right now, the implication is that informed investors don’t see anything which would significantly upset the outlook for utilities. That, in turn, implies low interest rates and continued corporate profitability. Since the DJUA has been a reliable bellwether for the SPX in recent years, investors should avoid falling victim to a bearish intermediate-term outlook.

Dow Jones Utility Average

Source: BigCharts

The impressive forward momentum in defensive areas like utility and real estate equities should also keep the S&P’s longer-term rising trend intact during periodic bouts of news-driven volatility like we’re seeing now. As unusual as it may seem, we may well end up seeing the market’s safety-oriented segments leading the next stage of the bull market as we head into 2020. At any rate, the impressive performance and forward momentum in the highly economically sensitive areas of utilities and real estate stocks suggest the bull market is still intact despite recent trade tariff concerns. I expect the SPX to pull through and re-assert its upward trend in this quarter and close out the year on a positive note. Based on some of the evidence we’ve reviewed here, investors are still justified in maintaining longer-term investment positions in equities.

On a strategic note, I’m currently long the Invesco Dynamic Food & Beverage ETF (PBJ). As discussed in a recent report, my research indicates that food retail stocks are among the top relative strength and earnings growth leaders of the broad market. I’m using a level slightly below the 34.20 level as a stop-loss for this trading position.

Disclosure: I am/we are long PBJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.