Trade Sectors That Are Lagging And Leading The Market

NOTE: Please click on the charts below to enlarge them if they do not appear clearly.

After opening near the flat line, the major indices rallied in the first hour of last Friday's session, but stocks subsequently reversed lower before finishing with moderate losses. The Nasdaq Composite slipped 0.3%, while the S&P 500 and Dow Jones Industrial Average each lost 0.4%. Both the small-cap Russell 2000 and S&P Midcap 400 indices declined 0.6%. As we often see on options expiration days, the session was choppy and indecisive, but the major indices settled near their intraday lows.

Volume surged higher in both exchanges, but this was largely skewed by the simultaneous expiration of options contracts for stock index futures, stock index options, stock options and single stock futures (SSF). Total volume in the NYSE rocketed 37% above the previous day's level, while volume in the Nasdaq swelled by 17%. While it's negative that the S&P and Nasdaq posted losses on higher volume, it's difficult to know whether volume would have also risen if not for the "quadruple witching" expiration of options. Market internals were negative, but not by a wide margin. Declining volume in the NYSE exceeded advancing volume by a margin of 2 to 1. The Nasdaq ratio was negative by only 3 to 2.

When the stock market sold off from February 27 through March 5, practically every industry sector fell sharply, making it challenging to immediately observe relative strength or weakness. However, some sectors have started to show divergence from the major indices since they undercut their March 5 lows and formed bullish reversals on March 14. Both the S&P 500 and Nasdaq Composite closed the week at 50% retracements from the highs of their initial bounce (March 9) down to their respective intraday lows of March 14. Lagging behind the S&P and Nasdaq, the Dow Jones Industrial Average concluded the week at just over a 38.2% Fibonacci retracement. Sectors that are closest to their March lows are the ones with relative weakness to the broad market, while those that are trading near their March highs are sectors with relative strength. Although the intermediate-term trend of the broad market remains down, the short-term picture of the market is more foggy. It's difficult to know whether the major indices will first test their March lows or highs, but sectors with relative strength will lead the market on the way up, while those with relative weakness will lead the way down. Knowing which sectors are leading or lagging the broad market enables you to position yourself with less risk and greater profit potential, regardless of which direction the market goes from here.

The Pharmaceutical Index ($DRG) has significantly lagged the broad market recovery off the March 14 lows. The index closed the week with a retracement of only about 20% off the March low, and is already trading below its 200-day moving average. Any further weakness in the broad market should quickly send the $DRG back down to test its low. With the 20, 50, and 200-day moving averages all overhead as resistance, this sector is not likely to reverse higher anytime soon:

Sister sector of the Pharmaceuticals, the Biotech Index ($BTK) has been showing major relative weakness since the sell-off began. It is one of the only sectors that was too weak to even bounce off its lows. Instead, it has merely "corrected by time," trading in a narrow, sideways range at its lows. If the stock market shows continued weakness in the coming days, look for a breakdown to new lows, below its 200-day MA:

The Internet Index ($GIN) is another sector that has been so weak that it failed to bounce off its lows. Like the $BTK, the $GIN has just been consolidating at its low. Both the 20 and 50-day moving averages are overhead as resistance, but it still has a good way to fall before running into its 200-day MA. The short side of the Internets may offer a better risk/reward ratio than Biotechs at this time:

As for potential long entries, there really aren't many sectors that have been showing clear relative strength. Utilities ($DJU) have perked up a bit, but there is a lot of overhead supply from the big drop at the end of February. Any breakout in the sector has a high risk of failure. Gold ($GOX) also showed strength into the end of last week, but there is resistance of the 20, 50, and 200-day MAs just overhead. About the only sector that looks decent for a potential buy is the Oil Service Index ($OSX). Unlike most sectors that are trying to recover from their lows, the $OSX has been consolidating near its high:

Of the major industry sectors we follow on a daily basis, these are the only ones that have shown significant divergence from the broad market in the short-term. All the others have moved with the S&P and Nasdaq, stuck in the middle of their recent ranges. Since there are several different ETF families that correspond to each sector above, we suggest downloading the free Morpheus ETF Roundup for a listing of all the major ETFs, grouped by sector and sub-sector for easy reference.

Open ETF positions:

Long SDS, TWM, short IYR, UTH (regular subscribers to The Wagner Daily receive detailed stop and target prices on open positions and detailed setup information on new ETF trade entry prices. Intraday e-mail alerts are also sent as needed.)

Deron Wagner is the head trader of Morpheus Capital Hedge Fund and founder of Morpheus Trading Group (morpheustrading.com), which he launched in 2001. Wagner appears on his best-selling video, Sector Trading Strategies (Marketplace Books, June 2002), and is co-author of both The Long-Term Day Trader (Career Press, April 2000) and The After-Hours Trader (McGraw Hill, August 2000). Past television appearances include CNBC, ABC, and Yahoo! FinanceVision. He is also a frequent guest speaker at various trading and financial conferences around the world. For a free trial to the full version of The Wagner Daily or to learn about Deron's other services, visit morpheustrading.com or send an e-mail to deron@morpheustrading.com .

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