#$rtm

On July 31, we posted a piece suggesting that the basic materials sector was threatening a material breakdown. Our rationale was the proximity of the Dow Jones U.S. Basic Materials Index to a confluence of key Fibonacci Retracement levels. As we have mentioned before these levels reflect the market’s tendency to “retrace” market moves in similar increments. We have also mentioned before that, in our view, the strongest Fibonacci signals come when there is a confluence of various such levels in the same vicinity. This was, and is, the case on the chart of the materials index. Oh, and that “material” breakdown did come to pass.

That breakdown on the Dow Jones U.S. Basic Materials Index occurred at around the 300 level. Note how the following 4 Fibonacci Retracements drawn from key lows in 2009, 2011, 2012 and 2013 to the 2014 highs, aligned almost perfectly with each other in that level:

23.6% Fibonacci Retracement of the 2009-2014 Rally  ~301

38.2% Fibonacci Retracement of the 2011-2014 Rally  ~302

50% Fibonacci Retracement of the 2012-2014 Rally  ~300

61.8% Fibonacci Retracement of the 2013-2014 Rally  ~302

Additionally, the 1000-Day (or 200-Week) Simple Moving Average is right in the vicinity as well.

We noted in that July post that:

Should the Fibonacci Retracement cluster around 300 fail to hold the index up, here is the next set of Fibonacci levels that the index would be likely to test (near 266, or 11% lower):

In the August mini-crash, the Dow Jones U.S. Basic Materials Index hit a closing low of...266. After bouncing for a few weeks, the index is once again testing that level.

Here’s a close-up look at the recent action.

That set of Fibonacci and other significant levels around the 266 area are the following:

38.2% Fibonacci Retracement of the 2009-2014 Rally  ~265

61.8% Fibonacci Retracement of the 2011-2014 Rally  ~266

2013 Lows ~266

Additionally, the 500-Week Simple Moving Average is right in that vicinity as well.

Should the Dow Jones U.S. Basic Materials Index bounce off the 266 area, its first big challenge may come at the post-crash bounce highs near 286. After that, it would be the 300 area. The problem for this index is, every potential line or indicator of support on the way down is now going to act as resistance on the way up. So even if the 266 level holds for now, the index would still have its work cut out for the foreseeable future.

Should this 266 level give way, there is really no noticeable, solid support until the 2011 lows which would correspond with the 61.8% Fibonacci Retracement of the 2009-2014 bull market. That level is around 210, which would signify a loss of over 20% from current prices. That’s on an index that is already off 25% from its highs. Not good.

We ended the July post by saying:

...if the (300) level fails, the Dow Jones U.S. Basic Materials Index is likely to visit the next cluster of Fibonacci Retracement levels near 266. Would such a move be a byproduct of an acceleration of the global deflationary trend currently in place? Or would it be a catalyst for a broader market decline? That is yet to be determined. However, such a breakdown would not be welcomed news for a stock market that has already seen its share of bricks removed from the wall.

Well, that dire scenario played out, in the basic materials sector and in the broader market. A failure of the current key support area would signify a deepening of these problematic trends that have unfolded over the past month. And as bad as things have been this past month, a further acceleration could be devastating.

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More from Dana Lyons, JLFMI and My401kPro.

We take a break from the regularly scheduled poor breadth programming to bring you a chart of a sector...that just so happens to be one of the main contributors to the poor breadth phenomenon. After threatening for months last summer to break out above its all-time high set in 2008, the basic materials sector succumbed to the October weakness along with the rest of the market. However, unlike most of the market, the sector, as represented by the Dow Jones U.S. Basic Materials Index, never did make it back to its September highs as it was caught in the deflationary spiral in commodities at the time. It did begin the year in promising fashion, though. In February, we posted that the Equal-Weight Basic Materials ETF, RTM, actually hit an all-time high, as did the Materials SPDR, XLB, despite the commodities rout. That victory was short-lived, however, and there has been precious little to cheer about in the sector since.

Earlier this month, the DJ U.S. Basic Materials Index became the first sector to actually move to a 52-week low. This was a fairly extraordinary event considering the major averages were still near their 52-week highs. The fact that the sector accounts for only 3% of the S&P 500 helps explain that possibility. However, the sector’s collapse has certainly played a role in the severe weakening of the index’s internals. And currently, the sector finds itself teetering on a very key level of potential support.

We refer quite a bit to Fibonacci Retracement levels as they reflect the market’s tendency to “retrace” market moves in similar increments. We have also mentioned before that, in our view, the strongest Fibonacci signals come when there is a confluence of various such levels in the same vicinity. No chart illustrates this point better than the DJ U.S. Basic Materials Index.

Note how the 4 Fibonacci Retracements drawn from key lows in 2009, 2011, 2012 and 2013 to the 2014 highs, are aligned almost on top of one another. In fact, it makes it difficult to distinguish each of the lines. Here are the levels to which we are referring:

23.6% Fibonacci Retracement of the 2009-2014 Rally  ~301

38.2% Fibonacci Retracement of the 2011-2014 Rally  ~302

50% Fibonacci Retracement of the 2012-2014 Rally  ~300

61.8% Fibonacci Retracement of the 2013-2014 Rally  ~302

Additionally, the 1000-Day (or 200-Week) Simple Moving Average is right in the vicinity as well.

Again, a cluster like this increases the confidence in the validity of the level. It should support prices, at least temporarily. Also, considering this is the first touch of this major level, it should provide support , initially. Interestingly, the index blew through the level (around 300) earlier in the week before recovering it. One might consider this a false breakdown and a springboard to a significant rally. However, we’d simply view it as a test of the support level so far.

How far could the index bounce if this support holds? We are not big on setting targets, but the first level to test would certainly be near 315, which represents the breakdown point below the previous 52-week lows. That would be a 4-5% gain from here and would certainly set up a tough level of resistance for the index.

Should the Fibonacci Retracement cluster around 300 fail to hold the index up, here is the next set of Fibonacci levels that the index would be likely to test (near 266, or 11% lower):

38.2% Fibonacci Retracement of the 2009-2014 Rally  ~265

50% Fibonacci Retracement of the 2011-2014 Rally  ~268

61.8% Fibonacci Retracement of the 2012-2014 Rally  ~266

2013 Lows ~266

Additionally, the 500-Week Simple Moving Average is right in that vicinity as well.

One interesting observation regarding the early-year rally is that, as several readers pointed out, the falling fuel prices served as a tailwind for the chemical companies in the index as it lowered their input costs. That enabled the new highs in the Equal-Weight Index and the XLB. In the recent (or on-going) commodity slump, the basic materials sector has shown no such signs of a rally due to lower input costs. What that means, we are not sure. Perhaps the weakness in the sector’s underlying business is outweighing the benefits accrued via low energy costs. At least, that is how investors are voting.

As mentioned, considering the multiple Fibonacci lines in the area as well as this being the first touch of the area, it should hold, at least temporarily. However, if the level fails, the Dow Jones U.S. Basic Materials Index is likely to visit the next cluster of Fibonacci Retracement levels near 266. Would such a move be a byproduct of an acceleration of the global deflationary trend currently in place? Or would it be a catalyst for a broader market decline? That is yet to be determined. However, such a breakdown would not be welcomed news for a stock market that has already seen its share of bricks removed from the wall.

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More from Dana Lyons, JLFMI and My401kPro.

People often ask us why we rely on objective, quantitative models to identify investment opportunities as opposed to popular theory, forecasts or intuition. One reason is that it assists us in avoiding perception bias. That is, the objective models are able to see conditions as they are rather than how we think they must be given the circumstances. A case in point: with the rout in commodities over the past 6 months, common perception may be that materials stocks are struggling in sympathy. A bias-free quantitative model would tell you that is not the case. In fact, would you believe that a broad collection of materials stocks is actually at an all-time high? Believe it.

As of a few days ago, the Guggenheim Equal Weight Materials ETF (ticker, RTM) did indeed hit an all-time high. The RTM, as its name implies, weights each of its holdings essentially the same, rather than the typical cap-weighted method. This way, the movement of 1 or 2 stocks alone is not likely to dictate the direction of the fund. Rather, a majority of the stocks need to be moving in one direction in order to get the fund going that way. In this case, the majority of materials stocks are rallying soundly, thus placing the ETF at an all-time high, a quite unexpected development given the commodity declines.

The location of the level from which the RTM recently broke out is noteworthy for a few reasons. The prior high point lines up precisely with two key Fibonacci levels:

161.8% Fibonacci Extension of 2007-2009 Decline

38.2% Fibonacci Projection of 2009-2011 Rally

If the breakout is successful, the breaching of these key barriers may provide further, material (no pun intended) upside potential, starting perhaps with the 61.8% Fibonacci Projection of the 2009-2011 rally (near $97, or 11% higher).

Lastly, a look at the sentiment picture for the sector is quite telling. From the terrific www.SentimenTrader.com service, we see that sentiment appears to be perhaps stricken with perception bias. According to SentimenTrader's proprietary models, sentiment on the materials sector, specifically on the popular SPDR Material ETF, XLB, is only just emerging from an extreme bearish condition. Similar extreme bearish levels have led to bottoms in the XLB and powerful rallies. This suggests, perhaps, that there is plenty of room aboard the materials bandwagon before it gets "overbought" or "overcrowded".

So we have a broad materials sector ETF at all-time highs, breaking above key resistance levels. At the same time, we have near-extreme low sentiment toward the sector, thanks likely to subjective perception bias stemming from the bear market in commodities. This is why we use objective, quantitative models in our investment selection. These models can locate opportunities in areas that, due to human nature, we may never even look at. Provided it can hold above the key breakout area, the Equal-Weight Materials ETF, RTM, may represent just such an opportunity.

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"Earthworms" photo by United Nations Development Programme