Industrial Select Sector SPDR ETF (XLI): Major Trend Reversal or Healthy Pause?

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This Market Regime Newsletter was issued on April 14th, 2024

After reaching an all-time high by the end of March, the Industrial ETF (XLI) has declined by almost 4 percent since then.
Following an impressive 26% performance since last October, this decline raises questions about whether the bull run in this sector has come to an end.
Despite this recent decline, we anticipate that momentum will soon pick up as the sector is still supported by a wide range of stocks maintaining a robust uptrend. This viewpoint aligns with the current market regime combination, which typically occurs during a healthy pause within a sustained uptrend.
Historically, the Industrial Select Sector SPDR ETF (XLI) saw gains in 73.1% of cases during long-term ‘Very High Reward’ market regimes. Conversely, during short-term consolidations within these uptrends (indicating a ‘Short-Term Increasing Risk’ market regime), it experienced an average loss of 1.3%.

Current Market Regime of the Industrial Select Sector

Description of the current Short- and Long-Term Market Regime

Short-Term Increasing Risk Market Regime:

Consolidation: Negative market regime, accompanied by low but steady increasing volatility. The market is taking a breather after a period of stronger gains, as sentiment typically reaches extremely positive levels. Thus, nobody is left to push prices higher. In a shorter-term perspective, the trend turns negative, which is supported by a wide range of negatively performing stocks within that market. Given the fact that the trend and the trend quality on a longer time perspective are still supportive, there is a chance that the market is getting back on track when sentiment turns fearful.

Long-Term Very High Reward Market Regime:

Robust uptrend: Highly positive market regime accompanied by significantly low volatility. Prices consistently show an upward trend, supported by a wide range of well-performing stocks within that market. Even in the face of negative news, the market demonstrates remarkable resilience with such a high positive trend quality. Weak trading days are typically short-lived overbought or sentiment driven reactions, leaving the market better positioned for further gains.

Driving Forces Behind the Current Market Regime:

Our definition of market regimes is rooted in an extensive analysis and combination of multiple indicators, aimed to identifying robust trends. To be more precise, trends are measured through a systematic screening of signals from multiple indicators across various categories (trend, trend quality, and sentiment, including dumb- and smart-money positioning) and timeframes. This diversified approach minimizes the impact of noise in individual indicators and enables an unbiased and robust view of current market conditions.

This is also illustrated in the spider chart below, which shows the current strength of each component (trend, trend quality, and sentiment). Here, we can observe that the current trend, trend quality, and sentiment in industrial stocks (XLI) have only weakened on a short-term basis, while maintaining robust readings from a mid- to long-term perspective. This is typical behavior of a healthy pause, as the consolidation is mainly driven by short-term profit-taking rather than by strategic selling pressure.

To monitor these performance factors over time, these signals are then combined into Market Health Indicators (as seen in the chart below). These indicators are representing composites of these signals for three different timeframes. Scores on a 0 to 100% scale denote signal positivity. Values below 50% indicate a negative outlook, while those above 50% signal positive market health. The combination of these health indicators results in market regimes, indicating the strength of the current trend for a specific timeframe.

The chart below illustrates the Industrial Select Sector SPDR ETF (XLI) in the first panel, followed by three subsequent panels detailing Short-, Mid-, and Long-Term Market Health over time.

Most of the time, the Industrials Select Sector SPDR ETF (XLI) consistently maintained a ‘Very High Reward’ market regime across both short- and long-term perspectives. These market regimes were driven by Short-, Mid-, and Long-Term Market Health Indicators consistently exceeding the 50% threshold, indicating a robust trend supported by a broad range of stocks in the sector and an increase in smart money positioning. As expected, the ETF witnessed substantial gains during these timeframes.

However, from September to November 2023, industrial stocks faced a challenging period as Short- to Long-Term Market Health dropped below 50%. This indicated that the majority of technical indicators covering trend, trend quality, and smart money positioning turned negative. In such a situation, the market is highly at risk for stronger pullbacks, leading to industrials declining by almost 15% during that timeframe.

How to spot high-reward & low risk market opportunities

3 Steps for Determining Market Regimes

With our structured approach, we can identify the respective market regime for any market. Our methodology include the following steps:

1

Identify Robust Trends

Trends are measured through a systematic screening of signals from multiple indicators (for example the WSC Trend Index, the Smart Money Flow Index or the Daily Put-/Call Ratio All CBOE Options)
These indicators cover various categories (trend, trend quality, and sentiment, including dumb- and smart-money positioning) and timeframes.
This diversified approach minimizes the impact of noise in individual indicators and enables an unbiased and robust view of current market conditions.

2

Monitor Market Health

These indicators are representing composites of these signals for three different timeframes.
Scores on a 0 to 100% scale denote signal positivity.
Values below 50% indicate a negative outlook, while those above 50% signal positive market health.
The combination of these health indicators results in market regimes, indicating the strength of the current trend for a specific timeframe.

3

Determine Market Regimes

By combining short- to mid-term and mid-term to long-term market health readings, the specific market regime is determined.
These Market Regime gauges help identify market regimes and shifts without the hassle of going through all indicator signals.
To be more precise, the Tactical Short-Term Market Regime is constructed upon the combination of short- to mid-term market health, while the Strategic Long-Term Market Regime is based on the amalgamation of mid- to long-term market health.

Additionally, in mid-May 2023, the Short-Term Market Health experienced a notable decline below the 50% threshold several times, indicating a lack of positive signals in trend, trend quality, and sentiment over the short term. Nevertheless, Mid- to Long-Term Market Health remained resilient. This combination prompted a ‘Short-Term Increasing Risk’ market regime, while the long-term view still suggested a ‘Very High Reward’ market regime. Consequently, the volatile phase during that time period was simply a healthy pause on the way higher.

Currently, we observe a similar situation. Short-Term Market Health has dipped slightly below the 50% threshold, while Mid- to Long-Term Market Health maintains strong readings above 50%. As a result, we strongly believe that the recent decline is just part of a healthy pause rather than the beginning of a more significant downtrend.

From Market Health Indicators To Market Regimes:

This positive market environment is reflected in our Market Regimes Gauges below. By combining short- to mid-term and mid-term to long-term market health readings, the specific market regime is determined. These Market Regime gauges help identify market regimes and shifts without the hassle of going through all indicator signals. To be more precise, the Tactical Short-Term Market Regime is constructed upon the combination of short- to mid-term market health, while the Strategic Long-Term Market Regime is based on the amalgamation of mid- to long-term market health.

What the history tells us about the current Market Regimes

Currently, the short-term shift in the market regime for the Industrial Select Sector SPDR ETF (XLI) appears to be a routine pause following a period of robust growth. Since 1999, the XLI ETF has transitioned into the ‘Short-Term Increasing Risk’ market regime 343 times. Notably, in 83.7% of these instances, the ETF experienced a decline, averaging a loss of 1.3%. During these periods, the average volatility measured 17.3%.

Conversely, the long-term perspective reveals a consistently favorable outlook, with the Industrial Select Sector SPDR ETF (XLI) maintaining a ‘Very High Reward’ market regime. This regime boasted a 63.5% win rate, delivering average returns of 3.4%. Remarkably, the highest return observed within this regime was 50.6%, while the lowest recorded was just -7%

The Bottom Line

With persistently positive Mid- to Long-Term Market Health Indicators, the recent decline just looks like a healthy pause on the way higher. Thus, we expect that momentum will pick up soon as the sector is still supported by a wide range of stocks maintaining a strong uptrend.
This view aligns with the current market regime combination, which typically occurs during a healthy pause within a sustained uptrend.
Looking at past data, highly leveraged investors should consider closing their positions when a market enters a ‘Short-Term Increasing Risk’ market regime, due to the poor average returns in this phase.
Given the fact that the downside potential is quite capped, a range trading approach might be quite an attractive strategy in such a market environment. Strategic long positions can be established again when the market shifts back to a ‘Very High Reward’ market regime.
On the other hand, long-term investors might see this pause as an opportune entry point to tap into this promising niche, relying on the continued strength of Mid- to Long-Term Market Health.

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