Pay Attention and Use Discretion

 | Apr 04, 2012 | 2:30 PM EDT  | Comments
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Stock quotes in this article:

xly

This article originally appeared earlier today on ETF Profits.

Consumer discretionary names have outperformed the market during the course of the current rally and displayed high relative strength vs. the broader market indexes. This strength is surprising considering the economic headwinds the companies in this sector face, such as relatively high unemployment and rising gasoline prices. We're considering the group as a leading signal of potential change in the market.

The sector is still on the offensive and continues to trend higher, but technical problems are developing. If a bearish catalyst breaks the sector's bullish price action, it could lead to a minor break in bullish sentiment and create a more meaningful corrective decline than we have seen so far in this rally.

The rally in the consumer discretionary index has been a steady, low-volatility move higher. The price action on the upside has been methodical, but the move is starting to look a bit extended and is growing vulnerable to a corrective phase on the downside. A pullback here would be healthy, normal and would refresh the current trend for another leg up.

Several technical divergences are developing, which supports the idea of a potential corrective phase pending. A bearish divergence exists between the price rate of change indicator and the sector price action. This divergence simply lets us know that the speed of ascent is slowing and bullish energy is waning a bit, which increases the vulnerability to a bearish catalyst.

XLY
Source: MetaStock

A bearish divergence also exists between the 40-day SARSI indicator (a measure of internal trend strength) and prices. Trend strength is weakening in the intermediate-term time frame, but the indicator is still holding at a fairly high level. The 200-day SARSI indicator is pegged at overbought levels and shows long-term uptrends holding across the entire sector, which tells us the consumer stocks are in a bull market.

Consumer Discretionary - 40-Day & 200-Day SARSI
Source: MetaStock

Another interesting divergence exists in the breadth line for the sector. Despite the strong trending action in the consumer index, money flows have not broken out above resistance and made new highs. Liquidity remains in a bullish position, but we should see the indicator easily trending higher. These technical divergences do not mean that the group has to move lower, they simply mean that the bullish energy is weakening and the sector is vulnerable to change.

Consumer - Breadth
Source: MetaStock

Consumer discretionary stocks have provided strong leadership and the group encompasses many of the highest relative strength names in this market right now. If this group breaks from the current extended position, it would likely signal problems in the broader market and suggest that a broader corrective process was under way.

The sector remains bullish, and the price action remains constructive, but the bearish divergences we've pointed out suggest that the bulls should increase caution and pay attention. However, we would not try to put the sector out short into the minor technical divergence we've pointed out. Instead, consider the group as a signal of market health as we gauge the ability of the rally to continue. Also look at the long side of the trade in this sector once a corrective phase runs its course, oversold readings are generated and the primary trend has been refreshed. The consumer discretionary sector is our 'canary in a coal mine' for this rally.

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