Indicator Says Buy Utilities

We have occasionally referred to an indicator we affectionately call SARSI. It stands for Self-Adjusting Relative Strength Indicator. It's a fancy name for something that is based on some very basic premises.

We created SARSI to help us define overbought and oversold conditions in sectors and major indices based on the objective participation of stocks in a sector. This indicator identifies when the majority of stocks in a sector have either rallied or declined by comparing the performance of the stocks in the sector against the sector as a whole, identifying extremes in buying and selling.

SARSI and the Utility Sector

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Typically, when the SARSI indicator reaches below 20%, the selling has reached an extreme, and the majority of stocks have participated in the decline. This is significant because it gives us an objective measure to gauge when the bears (or bulls) have exhausted themselves.

When oversold levels are reached, short positions become unproductive and traders should begin to look for long opportunities. It is not an exact timing tool, but we have found that within a five-day period from reaching an oversold signal, the rallies will begin.

The indicator is effective at finding tops as well. When the indicator reaches 80%, the majority of stocks in the sector are participating in the sector's rally, meaning leader and laggard alike are rallying. It is at this point when any further participation in the rally is unlikely.

Unlike bottoms, though, the tops take time, and we look for divergences as a signal the rally is maturing and nearing an end. We look at these measures over various time frames from short to long-term to identify shorter term trading moves and larger secular changes and we have found them to be effective over all time frames.

Utility Sector HOLDRs

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A group that has recently generated an oversold signal is the Utility sector. The Utility Sector HOLDRs (UTH Quote) is an ETFs that is a proxy for this sector.

When rates began to rise unexpectedly a few weeks ago, the utilities were hit hard and fast with some relentless selling. This pushed our SARSI indicator to oversold levels in the sector on a short- and intermediate-term basis. It's not easy to buy these stocks amid all the concern and weakness, but the SARSI indicator at oversold levels is telling us the selling was reaching a climax, and the probability of a snapback in the other direction is growing more likely. The indicator does not predict the magnitude of the move, only that a period of advance will occur after the signal is given.

In the case of the utilities, we have other confirming technical indicators. The group has pulled back to the weekly long-term uptrend line and has formed a bullish momentum divergence in the price rate-of-change indicator. This tells us that the group is losing downside momentum just as it approaches support. The confluence of oversold readings in our SARSI indicator, as well as the proximity to a rising support line and a bullish momentum divergence make a contrarian buy in the UTH a high percentage trade at this level. We would use a break of the rising long-term uptrend line at $135 as a stop-loss.