A very basic but time-proven way to measure risk appetite is to follow the performance of cyclical vs. non-cyclical sectors.
During better times for the economy, so-called cyclically sensitive sectors tend to outperform. More construction demand and discretionary income help industrial stocks like Caterpillar (NYSE:CAT) or consumer discretionary stocks like Dick’s Sporting Goods (NYSE:DKS).
On the other hand, a weaker economy will favor non-cyclical, or “defensive,” stocks — of the 10 sectors in the S&P 500, utilities, healthcare and consumer staples are decisively defensive — because people still need to eat, take their medicine, heat their homes and keep them clean and sanitary.
From a technical point of view, of the three defensive sectors, I like to focus on utilities as it trades in relation to more cyclical sectors. Specifically, I like to analyze the Utilities Select Sector SPDR (NYSE:XLU), an exchange-traded fund that contains some of the country’s largest utility stocks, including Duke Energy (NYSE:DUK) and Southern Co. (NYSE:SO).
From a longer-term perspective (four years), utilities look just fine, remaining in an uptrend that was confirmed in 2010.
However, warning signs for utilities arose in August that simultaneously gave a much more constructive buy signal for the broader equity market. With continued strength in the broader market in August, defensive sectors — particularly utility stocks — started to weaken, and the XLU broke an uptrend that had been in place since 2011.
In mid-October — this time much more in line with the broader market — the XLU made another run higher and retested the 2011 uptrend before eventually falling hard, right alongside cyclicals and most other equities.
While utility stocks fell along with the broader market in late October and early November, what is striking is the sector’s relative underperformance. Most cyclical sectors remain in a fairly healthy consolidation phase, but utilities look to have reversed course.
A closer look at the XLU shows the lower high that developed in October and eventually led to the sharp selloff. From an even more technical angle, note that the lower high corresponded with the 61.8% Fibonacci retracement of the July-highs-to-September-lows swing. The utility ETF then went on to hit the 23.8% Fibonacci extension target, and while doing so, also violently broke through its 200-day simple moving average (red line).
All of this leads me to think that the current correction in the S&P 500 and other U.S. stocks is a healthy one that should soon lead to stabilization, followed by a rally into year’s end. So despite utilities’ weakness, don’t short XLU — rather, play the relative outperformance of more cyclical sectors such as financials (NYSE:XLF), materials (NYSE:XLB), industrials (NYSE:XLI) and some technology (NYSE:XLK).