Rotation, Rotation, Rotation and Why I Like This Market Right Now

The purpose of this post is to show how I like how things are lining up for a rally based on technical analysis and the Sector Rotation Model.  Below is a an illustration of the Sector Rotation Model.  While a simple Google search will return many different looking models, I like the simplicity of the one below as the green dotted vertical lines align with sectors that outperform within the economic cycle.

SECTOR ROTATION THEORY

As you can see there are 5 green boxes above.  According to sector rotation theory and where the money flows, those sectors in the green boxes show which ones should outperform.  This makes sense as we look at boxes 4 & 5 (from left to right) money flows towards safety and yield in Healthcare and Utilities during a correction and beginning of a recession.  So where do I think we are in the economic cycle?  I believe we are between boxes 2 and 3.  To validate this thought I like to go to FinViz and their Sector Performance Grid in which they use a ranking system for the sectors.

What I like to focus on is the fall of Healthcare  and the rise of Technology and more notably Basic Materials.  The argument can be made about recent negative news and events (Syria, Middle East instability, etc.) in regards to the rise of Basic Materials but uncertainty breeds uncertainty and I don’t trade on what-ifs.  This brings me to the technical analysis of the market.

TECHNICAL ANALYSIS

Below is a basic price only chart of the S&P 500 showing the following and explanations of each number below the chart:

1)  Uptrend and Support line

2) Head and Shoulders topping chart pattern developing

3) Fibonacci Retracement

Explanations:

1) I believe the trendline to be valid as it is touching multiple points from top to bottom.  The uptrend has been violated and saw a down gap and follow through (see blue box in chart).  Also I like the support line as it also touches multiple points on a smaller timeframe and was violated via a big down day.  Also it saw a near touch on retracement with subsequent selling.

2) The Head and Shoulder (H&S) is developing and when you start hearing the buzz on news networks of “Head and Shoulders TOP” expect some more fear to enter the market and Joe Trader calling his broker being nervous.  A reputable backtesting chart pattern site is Thomas Bulkowski’s The Pattern Site.  Some interesting facts about the H&S topping pattern:

• Overall performance rank (1 is best): 1 out of 21
• Break even failure rate: 4%
• Average decline: 22%
• Pullback rate: 50%
• Percentage meeting price target: 55%

A reputable bearish pattern indeed but lets also look at the pattern I am anticipating, the Busted Head and Shoulders Top.  Please click on the links for specific rules & percentage numbers so that it fits to a “T” but basically this pattern is looking for a confirmed H&S top.  The top of the head, SPX 1709.76, then gets taken out and price rises at least 10% (1880.64).

3) From low to high Fibonacci Retracement we are currently consolidating at the 23.6% retracement.  Bearish by no means but healthy pullback it is.  If you have read “Goat Eyes” from @gtotoy compiled by @NVDA_trdr (years of tips for free, please please read) you will know that a failure of the 38% retracement is reason to get bearish.  That puts the SPX near 1570 and aligning with some support levels.  Level to watch for sure.

Lastly is a chart I posted Saturday morning highlighting the following, much annotated on the chart:

1) McClellan Oscillator divergences

2) Confirmation of McClellan Oscillator divergences, in this case the MACD Histogram

3) 100 EMA slope and test

4) Area of supply where I expect tugging/pulling

Explanations:

1) In the case of the McClellan Osc you can see the yellow lines in where I show divergences with the McClellan and in SPX, also annotated by yellow lines.  I like to look for the divergences that begin at mid-extremes, +150 or -150, keep note the +200 and -200 are highlighted on the chart.  But I have found the 150 level to be significant and avoid those short-term divergence whipsaws.

2) Please do not trade divergences blindly.  It is always prudent to use a confirming indicator as divergences can continue to diverge.  Will you always catch the top/bottom…no!  At least with a confirming indicator you can build confidence and still “build” a position with price later confirming your thesis.  In the case above you can see the blue box highlights where the McClellan readings were confirmed by the MACD Histogram.

3) I have written about the 100EMA in momentum stocks but also love to use it with the indices.  In this case you can see how the prior test held well.  It is important to also note the slope of the average.  If the 100EMA slope was down and we were testing it, I would consider it a bounce within a downtrend and not a retracement of an uptrend.  Notice the downward lower EMA’s (10, 20, 50).  They are in a downtrend, is this a reason to be bearish?  In my opinion, no as we still have a rising 100EMA & 200SMA.  If you were to be bearish because of those down-sloping faster EMA’s, notice what happened in late June, follow all the slopes, specifically the 100EMA.

4) Lastly the long blue highlighted box shows where I expect some indecision or profit taking on those that got long.  If we blow through this level and that high, expect some severe short covering.

In Conclusion:

Based upon the Sector Rotation Model and current Technicial Analysis I expect further bullish action rather than bearish, focusing on the Basic Materials sector.  I believe being bearish here is the unfavorable risk to reward.  I have to give credit to @gtotoy in that I have learned to buy support rather than short it.  While that sounds like simple advice, look at your news headlines, your retail sentiment, and current price action and tell me if it is easy to go long.  All those speak of bearishness but when you take an objective top-down approach (Sector Rotation, longer timeframe action) risk to reward favors being long.  Of course I could be wrong but ignoring news headlines and TRADING WHAT  I SEE is what works for me.  I plan to go long and let price prove itself, if wrong I lose small.  Also keep in mind this is from a longer term holding and not a swing trading perspective based on individual stock strength…unless of course your goal is met.