Reader Discretion is Advised (XLY)

We’re going to return today to one of the themes we highlighted in last week’s letter and attempt to explore it in somewhat greater depth.

For those who wish to go back and review our thoughts of May 15th, the letter was called Horrifying Research Reveals Rally-Ready Market.

Now onto business.

We were exploring the give and take between the consumer discretionary sector and the consumer staples, noting the relative strength of the staples during times of worry and that of the discretionaries when investor confidence prevailed. We produced for you a composite chart of the two using the Select Sector SPDR Consumer Discretionary ETF (NYSE:XLY) and the Select Sector SPDR Consumer Staples ETF (NYSE:XLP) – and wrote about them as follows:

The see-saw action between the two leads us to believe that we’re now at a point of extreme worry. If we had to bet, we’d go contrary – long XLY and short XLP in a pair’s trade, with the expectation that the gap will once again widen.

Since writing those words, we’ve had a closer look at the charts of both and while our assessment remains the same, we want to add some more color to the picture via a more in-depth look today at the discretionaries –

We’ll start here –

xly1

This is three years worth of daily chartitude for XLY and shows both the last meaningful pullback, beginning in the summer of 2011 and carrying through to January 2012 (blue box), and the subsequent rise to recent highs (in red).

The last major bottom saw the stock drop to the long term moving average (yellow line) before resuming its longer-term bullish course.

And a powerful bust-out it was. XLY climbed by better than 62% into March of this year before retreating to its current position at $63.46.

And there’s no doubt some technical damage was incurred during that retreat.

How bad is it?

Some would have you believe that we’re in the midst of a head and shoulders top (in black) that’s going to send XLY into the shadow of the Valley of Death and one would do better to overdose on sleeping pills rather than stay fully invested in the stock.

But we disagree.

In fact, we see technical signs that the discretionaries are improving. And we’re nearly certain that a bullish breakout for the sector is closer than most think.

But you take a look and decide for yourself –

xly2

The prospects of a head and shoulders top – and an ensuing cataclysmic decline – are far less threatening once we zero in on XLY’s recent price action.

According to our read, we could see a very strong move higher in the coming weeks if just a few conditions are met.

First, we note that the move lower from recent highs at $67.85 is comprised of two distinct down-waves (in red). Normally three waves lower – drawn from the highs, lower through subsequent retracement highs – fulfills the technical prescription for a bearish retracement. And now, that third wave is under construction.

That being the case, we say the bottom is in for XLY – a contention that’s supported by very active volume figures at the beginning of February (blue box) – and a breakout from the current pennant pattern is just a matter of time.

Pennant Pattern Indicates a Continuation of Trend

Price action off February’s bottom is bounded on the bottom by the rising four-month trendline (in black) and on the top by the declining wave II red line.

A close look reveals that the resulting pennant pattern has been broken on the upside, indicating, at best, an immediate move toward former highs at $68. At worst, we could slide sideways until that third wave is complete and the move can again resume.

Either way, we’ll also have to climb above the 137-day moving average, which, because it’s currently rising, should not present any meaningful resistance.

But what about the head and shoulders top, Huey?

Head and shoulders tops are serious affairs, but it’s not clear that this one is. We would have to see a broken neckline and the stock dropping to the $62 range before we would confirm XLY was genuinely in danger.

Conversely, if the pattern were to be broken on the upside – that is, if the stock ascended higher on a breakout from the current pennant and pierced the former highs at $67.85, we would likely see wild technical buying that would push the stock appreciably higher.

Note, too, that we’re only talking about a seven percent rise from current prices – not an everyday move, but not an impossibility for a stock like this over the course of a week or two, particularly given the advanced nature of the pennant pattern on the chart.

So let us reiterate.

XLY’s a buy.

Many happy returns,

Matt McAbby
Senior Analyst
Normandy Research

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