By Sean Dillon
Momentum is an important tool in the technical analyst’s toolbox. As we learned in physics 101, momentum is defined as mass velocity, or in layman’s terms, the speed at which something is moving. As with all universal laws, technical analysts can apply this concept to stock prices to determine stocks that have strong or weak momentum, and invest in the former over the latter.
There are a variety of momentum indicators from which to choose, but my favorite has always been the Relative Strength Index (RSI). RSI is an indicator that measures momentum by comparing the strength of gains and the strength of losses over a certain time period, oscillating between 0 and 100. Stocks with strong momentum tend to achieve RSI scores above 70 while stocks with weak momentum tend to achieve scores below 30.
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In the example below we are analyzing the Materials Select Sector SPDR Fund (XLB). In the top pattern is the price chart and in the bottom panel is the 14 day RSI. The 14 day RSI, not surprisingly, uses the average gains over the last 14 days and compares them to the average losses over the last 14 days.
In analyzing the RSI, we can see that XLB had strong momentum off the February bottom as the indicator moved above 70 in both March and April, and it did not fall below 30 during the June correction. However, on the July move higher in price the indicator failed to move above 70, creating a divergence in price and momentum. Momentum was weaker as illustrated by the falling red line and is a warning signal that price may start a new move lower.
Adding a trend line to the price chart can enhance our analysis. The blue line is a rising trend line that has acted as resistance to every price advance in this ETF. Resistance is the point at which supply overwhelms demand and the price cannot move higher with that imbalance. At the same time, we saw the momentum divergence (with one brief day above) price being resisted by this trend line, reiterating the point that XLB might move lower.
Moving to the Consumer Discretionary Select Sector SPDR (XLY), we can apply the same principles to this ETF. RSI points to the same strong momentum off the February bottom as the indicator moved above 70 in March and barely stayed above 30 on the June correction. However, the same divergence and failure to reach 70 has been marked by the red line. The difference for XLY is in the price chart. The price of XLY has moved above previous resistance which was the high price points in November and December. With this price breakout, if the RSI moves above the falling red line and goes above 70, it could portend nice price gains in the future.
If however price confirms the weakening momentum profile and moves back below the blue line, this would mark a classic ‘failed breakout’. A failed breakout is a price movement above resistance that cannot hold causing many traders to sell positions because big price gains can no longer be expected. At just 2.86% of the S&P 500 price weakness in XLB may or may not lead to price weakness in the S&P 500, but at 12.5% XLY is much more important to monitor!