When I’m looking through charts for my next trade, a few things can catch my eye…

It might be a share price tanking after releasing bad news, or even soaring after receiving a takeover offer.

While those examples are stock-specific, it’s rare to see that type of abrupt movement in a sector-based ETF.

However, one sector that’s gone for an extraordinary run over this past month is the consumer discretionary sector. This sector is made up of companies that sell nonessential goods and services, such as appliances, cars, and entertainment.

To trade this sector, I like to use the Consumer Discretionary Select Sector ETF (XLY). Up until October, XLY was going through a relatively benign year…

The long-term 50-day moving average (MA) had been slowly trending higher all year.

At the same time, the short-term 10-day MA had been crossing back and forth across the 50-day MA without any clear breakout trends.

However, all that changed in October, just take a look…

Consumer Discretionary Select Sector ETF (XLY)

Source: eSignal

From mid-October, XLY went on a tear. Since October 13, XLY has rallied close to 15%.

You can see on the chart just how strongly and quickly the 10-day MA is breaking higher and away from the 50-day MA.

A big part of that has to do with how XLY is comprised. Just four stocks account for around 52% of its holdings: Amazon (22%), Tesla (16%), Home Depot (9%), and McDonald’s (5%).

While both Home Depot and McDonald’s have had strong months (less so for Amazon), it’s Tesla that was really responsible for launching XLY higher.

In the last month alone, Tesla has rallied around 50%. A record earnings report and a big order from Hertz was the catalyst for its latest big move.

But, what’s next for XLY? And how can we trade it?

One of the answers lies within the Relative Strength Index (RSI).

So, let’s go back to the chart…

Consumer Discretionary Select Sector ETF (XLY)

Source: eSignal

As you can see, as XLY burst through the $200 level and higher, the RSI also went through the roof.

Right now, the RSI is reading at around 83% – that’s a long way above the 70% benchmark that typically represents an overbought signal.

However, one thing we need to consider is the way the RSI works.

The RSI calculates the number of up days versus down days of a stock over a two-week period. It then uses the size of those gains or losses to determine the stock’s overall momentum.

When a stock price quickly jumps higher (like XLY), it can initially skew the RSI higher too. Meaning that the RSI might go into overbought territory before buying momentum fizzles out.

Sometimes, it might take a few days for that distortion to iron out in order to get a more accurate reading from the RSI.

The other thing to consider, though, comes back to the nature and construction of ETFs…

We know from Tesla’s 50%-plus gain and its 16% weighting in XLY that it’s by far the biggest contributor to XLY’s recent breakout.

For XLY to keep rallying at its current trajectory, it means Tesla will have to do so too. And that means Tesla would have to rally another 50% over the next month to see another 15% rise in XLY.

Is it possible? Yes. But, probable? Well, that’s a different story. We’ll have to see what happens over the coming weeks to see how that pans out.

For now, Tesla only needs to stall for some of that buying momentum in XLY to evaporate, and that would cause the RSI to invert.

Another way to view it is that XLY needs Tesla to keep rallying strongly, otherwise the sheer weight of the other 84% of its holdings will bring XLY back to Earth.

And if that happens, we’d be in a prime spot to enter a short trade on XLY.

Either way, there could be a big opportunity in XLY ahead.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

Reader Mailbag

I love hearing from eager readers about certain concepts or topics they enjoy. Below are some of the latest responses…

Hi Larry,

Your newsletter is the first email that I read in the morning. Your insights have tremendously helped me navigate the markets, and I’m sticking with your expertise.

I especially appreciate your simple approach to picking direction in sectors, rather than individual stocks. I’m grateful you’ve taken the time to help the little people like me out there realize their dreams. Keep up the good work!

– Jeff

I enjoy reading your explanations of the stock charts. I have a January call on GDX. I hope it rallies big time.

– John

Good evening Larry,

I follow you every day. Your job is great, it gives me tons of ideas! Congratulations. Thanks for all of your eletters!

– Flavio

P.S. We’re excited to hear what you think of your new eletter, Trading With Larry Benedict. Let us know at feedback@opportunistictrader.com.