Potentially the most important charts you will see this week. The weakness in the broad US equity indices hasn't been confirmed by two very vital ratio's. We, as traders or investors, occasionally forget that indices like the S&P 500 don't necessarily represent the whole equity market. It's therefore necessary that we take closer looks at the stock market to try and truly understand the state the markets are in. That's why most of us look at breadth indicators such as the new highs and lows or percentages of stocks above key moving averages, sentiment, earnings, and even a couple of macro charts, all to truly better understand the situation. Talking about all of them is beyond the scope of this post so we're going to keep it short by looking at two very important ratio's arguably telling us what's under the hood of the stock market.
The two ratios I'm talking about are the consumer discretionary versus
consumer staples and the small-caps versus the large-caps. A quick explanation
on these two ratio's is in order.
Consumer Discretionary vs. Consumer Staples
The first ratio is the XLY vs. the XLP. When times are fun and bustling (economically) then consumers will usually have a little extra discretionary income that they can use to spend on fun stuff, like going out to restaurants, buying expensive clothes, cars, furniture, you name it. The companies (Amazon, Disney, NIKE, McDonald's,...) that benefit from these shopping sprees you can find in the Consumer Discretionary sector fund ($XLY). Companies like these are a little more sensitive to how the economy is faring. What if times aren't fun though? Well, consumers still need to drink and eat and buy medicine. This is represented in the Consumer Staples sector fund ($XLP). The stocks within this fund are your classic defensive companies like Procter and Gamble, Coca-Cola, Kellogg, Kraft Heinz, Walgreens,...The stocks of these companies aren't (relatively speaking) really impacted by economic swings. So, based on this info you should already be able to understand which fund would perform better when the market is in a healthy uptrend. When the market is doing well, Consumer Discretionary will do a lot better than the Staples and vice versa.
Below you can find the chart of how the XLP/XLY ratio compares to the SnP500, you can clearly see the inverse relationship between the two:
However, the more clearer chart is the Discretionary vs. Staples ratio. The most important part is the divergence we're seeing. The S&P 500 made a new low while the ratio hasn't. This is vital information as a divergence was also seen in the beginning of January when the current decline began.
Small-Caps vs. Large-Caps
The second ratio is the Russell 2000 vs. the Dow Jones. Why is this ratio important? When small-caps are outperforming large-caps, this basically means that the big players: hedge funds, banks, pension funds, etc. are bullish because it's clear that they are letting their capital flow into small-cap companies which frequently exhibit more speculative characteristics. These companies will theoretically see quicker growth of their stock prices during good market environments. This is a big contrast when compared to the bigger, already-established companies that you'll find when looking at large-cap stocks. If these big money players are worried about the market, they would rather keep their money in more “safer” large-cap names that should hold up better in a market decline due to their lack of volatility and already established reputation.
The divergence we saw above on the XLY/XLP ratio we're seeing on the IWM/DJI ratio as well. So, no point in repeating what we saw above. Below you can find the charts combined for a more easier viewing.
What do you think? Is this enough too warrant a change of opinion on what the market might do next? We've seen the Fed's tone change a little too during the last couple of days and the US midterm elections are coming up too which has historically been a really strong period for stocks. So, could this be the spot to start calling a potential bottom? Or are we going to experience more pain in the next couple of months? Let me know what you think.