In trending markets, investors and traders alike have a tendency to forget how quickly corrections and other countertrend moves can appear out of seemingly nowhere, and how sharp these moves can be. Case in point: the utilities sector, , as evidenced by the Utilities Select Sector SPDR (XLU), which rose 18.6% from the start of the year through April 30, followed by a swift down move in the past four weeks.
As the broader U.S. stock market rallied in 2013, fueled by global central bank monetary policy posturing and improving economic data, investors in search of income piled money into dividend-paying stocks and sectors, such as the utilities.
All of this changed rather quickly in early May, when investors began fretting over a potential backing off of quantitative easing, resulting in bond prices falling and yields rising. They began quickly moving out of dividend-paying stocks such as utilities in preparation for a higher-yield environment.
On the chart of the 10-year U.S. Treasury note, the sharp rise in yields starting in early May is visible. Yields rose almost 40 basis points and are now just over 2% and near the year's highs from March.
On the multi-year chart of XLU, it appears to be in good shape to reach higher prices over time, but given its year-to-date gains, is likely somewhat overbought in the medium term. The recent correction puts XLU a little more than 6% off its late April highs and right back into the uptrending channel (blue parallel lines) that dates back to the 2009 lows.
The sharp correction is yet another example of a chart gone vertical that ultimately gives way to the law of gravity -- what goes up must come down. Note how XLU topped just as it peeked out of the longer-standing channel.
The daily chart below gives us more clarity on the near-term support and resistance zones that swing traders should focus on.
First, note that last week's 3.7% drop took XLU below its 50-day simple moving average for the first time since the start of 2013, when the rally that began in November kicked into high gear.
The recent sell-off also resulted in XLU closing last week right at the August 2012 highs, which acted as resistance until late March. By definition, previous resistance levels should act as first meaningful support, and thus, the $38.50 area should be watched for a bounce.
Given the sharp drop from the high-momentum top in late April, the odds now favor further selling after a potential initial bounce attempt. As markets often take the path of maximum frustration for investors, a bounce from last Friday's closing levels may just be enough to confuse the crowd. Therefore, a bounce into previous mini support (now potential resistance) near $39.50 could offer traders looking to short XLU a defined level to trade against.
The 50% and 61.8% Fibonacci retracement areas of the November 2012 to April 2013 uptrend stand out as potential downside targets.
Recommended Trade Setup:
-- Short XLU between $39.50 and $40.30
-- Set stop-loss at $41
-- Set initial target at $37.65 for a potential 5%-7% gain in 4-8 weeks
-- Set secondary target at $36.85 for a potential 7%-9% gain in 4-8 weeks