The FRED Report ( www.thefredreport.com) has been writing about the possible Head and Shoulders Bottom formation on the S&P 500 in recent weeks. See last week's article for a full description of this pattern and why it is bullish for the markets. Today, we will talk about some sectors that are important if this rally is to continue.

The first is the SPDR Select Sector Financial ETF (XLF), our favorite proxy for the financial stocks. The XLF has lagged the market and has been an underweight in our sector work since 2008. While the financial stocks performed well for part of 2009 and 2010, this was mostly a rebound from very bad performance in 2008. However, in recent days we note that the sector has improved and is close to 15.50, which would be a breakout of the last few months' trading range.

Stock selection is important and we note that Insurance and Brokerage stocks are trading better than Banks. Favorite stocks in the sector include GS and MET.

Stocks we dislike include BAC and C.

Our favorite bank in the sector is JPM and you can see how much better this name is performing than aforementioned banks.

Our other underweight has been the SPDR Select Sector Healthcare ETF (XLV). The XLV started to lag the market in January of 2010 and until recently has been moribund. However, the daily chart shows the patient is finally showing signs of life.

Favorite stocks in this sector include BMY and UNH, while less attractive alternatives include GILD and MDT.

 

While this sector will likely remain an underweight in our work due to long-term relative underperformance, the short-term action supports a further rally in the stock market.

We believe that current investor pessimism is not borne out by recent stock market performance. Seeing improvement in two of the weakest sectors of the market bolsters our positive view and is cause for optimism. In particular, seeing improvement in the Financials suggests that one of the weakest areas of the economy is improving and this is a significant change, in our view.

Fred Meissner is founder and publisher of The Fred Report. Fred is a CMT and past President of the Market Technicians Association (MTA). He recently left Merrill Lynch's Market Analysis Department and Sector Strategy Department to form The Fred Report. A detailed bio is here: Fred Meissner.