A well-known nugget of investing wisdom says that when a key leadership group stumbles, it’s a bearish sign for the rest of the market.
This year has already brought underperformance for retail stocks and small caps, and now another group can be added to the list: industrials.
Industrial stocks have been one of the key engines of this bull market, rallying off their depressed post-crisis levels to deliver strong outperformance in the recovery. In the five years ended June 30, the Industrials SPDR (XLI) delivered an average annual return of 22.24%, thumping the 18.69% return of the SPDR S&P 500 ETF (SPY).
This story has changed considerably in July. XLI has lost 2.1% so far this month through July 29, trailing the 0.6% gain of the S&P 500 Index. Among the key culprits in the shortfall have been General Electric (GE), United Technologies (UTX) and Boeing (BA).
Underperformance of less than 3 percentage points might not sound like much, but from a technical standpoint, it carries a great deal of importance.
XLI Is Walking on Shaky Legs
XLI’s slump has taken it below a well-established, two-year-old trendline, making it the only one of the major sector ETFs to be exhibiting this type of weakness.
Further, Thursday’s weak open put XLI within striking range of its 200-day moving average. As of late Thursday morning, XLI was trading just above $52 — pennies away from its 200-day moving average at $51.85. This places the industrials sector in immediate jeopardy of a breakdown, and investors should heed this as a danger sign.
This is an important development not just because of industrials’ leadership status, but also because the sector has acted as a warning signal in the past.
In 2011, for instance, XLI broke down several days before the broader market declined more than 18% in reaction to the first debt ceiling crisis.
This comparison isn’t intended to act as a prediction that the stock market is on the verge of a similar meltdown this time around. Instead, it’s an alert to investors to keep a close eye on XLI’s 200-day MA, and to monitor this sector for continued weakness.
If industrials can’t gain traction, it’s unlikely the rest of the market will be able to do the same.
The Trouble With International Exposure
There’s another message to be gleaned from the underperformance of the industrials sector in July.
Even as U.S. data shows signs of an acceleration here at home, companies with above-average international exposure are vulnerable to the ominous economic signals coming out of Europe. Growth has begun to slip once again, and the region is perilously close to sliding into deflation. While the increasingly aggressive European Central Bank might address this by announcing a quantitative easing policy — which would surely reverse any concern about international exposure — for now it doesn’t pay to have a large portion of revenues coming from outside of the U.S.
This goes hand in hand with the rally in the U.S. dollar in July. While the move in the greenback still is in its early stages, the fundamentals are in place for the uptrend to continue. If this indeed proves to be the case, companies with high non-U.S. dollar revenues — a group that includes industrials — will be in jeopardy of downward estimate revisions.
Industrials are at ground zero of a number of important trends in the financial markets, so keep a close eye on XLI’s behavior around its 200-day moving average — it could be a clear indicator that the long-awaited market correction is finally in the offing.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.