Since pulling the market higher for the first four months of 2013, the utility sector has fallen out of favor. While it’s a positive change in leadership for the broader market, the emergence of relative strength from more offensive sectors like consumer discretionary, energy and financials has largely come at the expense of the utility space.
Although the Utilities SPDR (XLU) is a mere 3% off its bull market highs, on a relative basis it’s underperforming notably. Let’s head to the charts to see what they suggest about the future of this struggling sector.
Click to Enlarge A brief investigation of XLU reveals three signs of deterioration that warrant caution for the bulls.
- Alongside the recent downturn in XLU, the comparative relative strength (CRS) line reversed from an uptrend to a downtrend, indicating XLU has shifted from outperforming the S&P 500 to underperforming. Like a flashing red light, the falling CRS line should act as a warning sign to avoid bullish plays in utilities for now.
- The early May pullback was accompanied by higher-than-average volume, which suggests institutional selling or distribution. The reason distribution days strike fear in the hearts of the bulls is because institutions rarely unload their positions all at once. Because of their enormous size, they typically sell shares over time, which often exerts continued downward pressure on whatever stock or sector is in their crosshairs.
- Depending on how the current rebound in XLU plays out, we might have a head-and-shoulders top in the making. To complete and confirm the pattern, XLU would need to roll over and break the neckline support level at $39.40. Subtracting the height of the pattern from the neckline yields a downside target of about $37.34.
Now, as ominous as these developments might seem, keep in mind that the equities market remains firmly entrenched in a raging uptrend. Outside of gold, silver and perhaps a few other areas, bearish opportunities have been a rare commodity in this environment. It truly has been a market that has eventually lifted all boats.
Nonetheless, if you’ve been on the lookout for a low-risk entry point for bearish plays, Utilities seem to be providing it. Here are two strategies worth consideration — one aggressive and one conservative:
Buy the July 41 put for $1.40. The max risk is limited to the initial $1.40 paid and the max reward is unlimited.
Buy the July 41-39 put spread by simultaneously purchasing the July 41 put and selling the July 39 put for 97 cents. The max risk is limited to the initial 97 cents, and the max reward is limited to the distance between strikes minus the net debit, or $1.03.
To further reduce the risk in both positions, consider exiting if XLU breaks back above $41, negating the potential formation of the head-and-shoulders top.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.