Measured across multiple time intervals, changes in relative strength are a highly reliable predictor of directional change in absolute price. Then, carefully practiced, regular relative strength monitoring of market leading sectors can help signal directional price change in the averages themselves.
With that in mind, the XLF’s current relative strength pattern below should be of interest. Financials led the S&P rally to its top in July, but have lagged conspicuously since. Notably, attempts to return the sector to market leadership in July-August failed badly. Rolling indicators now suggest there won’t be a third.
But the validity of trading signals most often is no better than the primary trend signals confirming them. In the primary trend XLF/SPY pattern below, the cautious trading signal is not only confirmed by the weekly’s trend line break, it is further validated by the important break in the weekly indicator below the price panel. The still recent break suggests the XLF lag will only worsen over the medium-term.
Were it not for the preceding perspective, the daily trading pattern the XLF itself has traced out below would seem nothing more than a modestly lagging rally.
But in the reflection of the sector’s atypical and increasing relative weakness recently, the lagging rally can be seen as the first failure of the financials in two years to go on to a new rally high, following a 3+% pullback.
Despite the signal, however, it’s seldom prudent to suggest rotation away from any sector – particular a leadership sector – absent confirmation from the primary trend. That’s why the following weekly XLF pattern is important.
Although conventional evidence of a breakdown is lacking, the chart offers compelling second derivative indication that financial sector stocks are putting in a medium-term top, if not worse. And, judging by the obvious divergence developing these past two months and the inflection profile of the indicator, similar to that which preceded the sharp sell-offs in the XLF in 2011 and 2012, it wouldn’t take much technical imagination to conclude that such a top might lead to meaningful damage. Clearly, risk in the sector is rising.
Now, whether or not the S&P could overcome the loss of financial sector leadership is a tougher, riskier call. All we know is that hasn’t had to for more than two years.
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