The One Chart Stock Market Bulls Can’t Ignore

There are many indicators that can give us an idea about where key stock indices may be headed. It may seem obvious, but always remember that nothing is certain until it happens. As I say quite often in these pages, trying to predict the exact top and bottom on key stock indices can significantly damage your portfolio in the case that the markets move in the opposite direction. 

When I am trying to figure out what the next move will be by the key stock indices, I look at investor sentiment; I look at where investors are placing their money and what kind of assets they are buying. For example, when investors think the risks on key stock indices are increasing, they go towards safer stocks—big-cap companies may be one example. On the other hand, if investors think the key stock indices are moving to the up side, they move into stocks that provide better-than-market returns. 

One indicator of investor sentiment that I look at is the relationship between the Utilities Select Sector SPDR (NYSEArca/XLU) exchange-traded fund (ETF) and the Morgan Stanley Cyclical Index. The XLU tracks utilities companies that are considered safer by investors because their products or services are needed regardless of economic conditions, like electricity providers, for example. On the flipside, the Morgan Stanley Cyclical Index tracks cyclical stocks, which are the stocks that move with the markets and are considered riskier assets, like furniture retailers, for example—they are dependent on how the economy is doing overall. 

With this in mind, please take a look at the chart below. It shows the movement in the XLU and cyclical stocks. At the bottom of the chart, I have plotted the performance of the S&P 500.

Chart courtesy of www.StockCharts.com 

As is shown in the chart above, an interesting phenomenon is taking place. The utilities stocks are increasing and the cyclical stocks are sliding lower. This tells me that investors believe risks are increasing on the key stock indices. As this is happening, we also see the overall market, represented by the S&P 500, is sliding lower as well. 

Will the key stock indices continue to slide lower? 

Looking at the strength in the utilities stocks and the weakness in the cyclical stocks, the key stock indices do look to be facing some downside risk. On a global macro-economics level, we are hearing how the emerging markets are facing troubles. This could add more to the risks already at hand in the U.S. economy. 

If the key stock indices slide lower, investors can protect their wealth by adding an ETF like the XLU to their portfolio. The other strategy investors may consider taking is to look at ETFs that short the overall market. One of these ETFs may be ProShares Short Dow30 (NYSEArca/DOG). This ETF increases in value when the Dow Jones Industrial Average declines.

~ by Mohammad Zulfiqar, BA 

This article was originally published at Daily Gains Letter