Don’t Let the Market Rally Fool You; Buy the Dip in This Sector

After a record-setting rally in bonds, the better-than-expected June jobs report gave bond traders an excuse to bank some fat profits. However, a look under the hood shows that, structurally, nothing has really changed.

The bull market in bonds and trend toward lower interest rates remain intact. And that is why I’m now looking for a good place to buy the dip… in the utilities sector.

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Despite this week’s pause in bond prices, the yield curve — the yield on the 10-year Treasury note minus the yield on the two-year note — is still in a flattening trend and narrower than it has been in years. The flatter it gets, the more likely the economy will see problems. Banks in particular find it more difficult to profit when their cost of money, borrowed at the short-term rate, is close to or even greater than revenue received at the long-term loan or mortgage rate.

The trend around the world is for government bonds to offer negative interest rates. Given the choice between German or Swiss bonds at negative yields and the 10-year U.S. Treasury note at 1.5%, it’s pretty obvious where dollars will flow.

And for those worried about repatriating their income back to Germany or any other country, all we have to do is look at a chart of the U.S. dollar index, which notched an upside breakout following the Brexit vote. That favors non-U.S. investors and makes U.S. bonds even more attractive for existing owners.

Basically, the U.S. market is one of the only games in town. Perhaps traders used the jobs report as their excuse to give stocks, which have an even higher yield potential, a go. (There is a lesser-known way U.S. investors are bringing in an extra $850 a week in income. Find out how here.)

So, what’s the problem? Buy stocks and sell bonds, right?

Well, not exactly…

With the S&P’s 500 break to fresh all-time highs after more than a year, there is great buzz for stocks and the financial press is rife with bullish calls. But despite new highs in the S&P 500, as well as the Dow, many of the major indices, including the Nasdaq, are still below their prior peaks. Therefore, in my opinion, the case for the dawn of a new bull market is not yet convincing. Sentiment seems too frothy already. And the major trend in bonds, the newly minted bullish trend in gold and even the one-year trend in the Japanese yen — the current safe-haven currency — all argue the same non-bullish case for stocks.

All of these safety markets pulled back this week, but they have not reversed their rising trends.

For starters, even after Tuesday’s rather sizeable dip, the Treasury bond market is still above its major moving averages. Using the iShares 20+ Year Treasury Bond ETF (NYSE: TLT) as a proxy, we can see the steep trend punctuated by the occasional gap-down sell-off. 

Keep in mind that bonds rallied Friday after the jobs report as stocks began their ascent. Even Monday, when stocks were still moving higher, TLT stayed steady. Only on Tuesday did the ETF finally suffer a significant loss. That shows resilience.

Furthermore, money flowing into the ETF remains in a rising trend according to the on-balance volume indicator. Even as this overbought market prepared for a dip, volume on rally days exceeded that on decline days. That tells us demand is still solid.

So, why am I planning on buying utilities on the dip as opposed to Treasuries?

Well, I am a little worried about the bond market and its stingy rates of return. Utilities offer dividend yields north of 3% to provide a hedge against a wrong call.

The Utilities Select Sector SPDR Fund (NYSE: XLU) provides a liquid vehicle for this strategy and mitigates the risk of any single stock. As we can see in the chart, it has a good deal of room to drop before reaching its supporting trendline from December. 

There is also horizontal chart support near the trendline from the recent high in March. And as with TLT, XLU also enjoys a solid rising trend in on-balance volume.

I’d like to offer a more complex analysis, but it’s that simple. I don’t think the bull market in bonds and bond-like instruments is over and, therefore, a test of the trendline is where I want to buy the dip in XLU. The upside target is the top of the trend channel containing the bull market since the 2009 bottom.

To mitigate risk, we’ll have a rather tight stop-loss level in case the trendline breaks to the downside.

Recommended Trade Setup:

— Buy XLU at $50
— Set stop-loss at $48
— Set initial price target at $55 for a potential 10% gain in six weeks