Have I got an interesting chart for you today!
But first, let’s get one thing cleared up right away: technical analysts, like me, DO care about fundamentals. We just look at them through a different lens, compared to how economists look at them. Rodney’s astute analysis of retail sales figures is a perfect example of this.
As Rodney says, per capita retail sales are declining. That’s concerning because consumer spending makes up more than 70% of U.S. GDP. A slowdown here spells trouble for economic growth and eventually the stock market.
Of course we technical analysts care about fundamentals. But there is a depth of value and insight that technical analysis, when used wisely, can provide that fundamentals alone can’t.
We don’t JUST look at stock prices to make assessments. We also look at the underlying “inner workings” of the markets… just from a technical perspective.
The Discretionary/Staples ratio is a perfect example of this…
Instead of looking at retail sales as Rodney does, I like to monitor the relationship between Consumer Discretionary and Consumer Staples stocks.
I do this because strong performance among Consumer Discretionary stocks is an indicator of market strength. For one, if consumers are buying discretionary items (things they don’t NEED, but just WANT), you can assume they’ve paid all their bills and have some extra cash to spend on such luxuries. That’s a positive sign for the economy and stock market. Also, aggressive investors typically favor discretionary stocks over staples, providing further insight into the market’s mood.
On the other hand, if Consumer Staples stocks are outperforming discretionary stocks, it’s a clue that consumers, and investors, are being more conservative… pinching pennies and saving for a rainy day.
So without further ado, here’s a chart showing the ratio of Consumer Discretionary stocks (XLY) versus Consumer Staples stocks (XLP). The ratio (green) is plotted over the S&P 500 (white bars).
As you can see, this ratio tracks the S&P 500 remarkably well and should be in every technical analyst’s toolbox.
The key to using this ratio as a means toward forecasting the broad market’s trend is in watching for confirmations and divergences.
Basically, if the stock market is in an uptrend – making higher highs and higher lows – you want to see the XLY/XLP ratio line confirming this… itself also making higher highs and higher lows. This tells you the underlying strength of the bull market is intact.
Divergence, on the other hand, can provide an early warning sign that trouble may be ahead. This happens when the stock market is strong, but the XLY/XLP ratio weakens.
If you look back to the chart, I’ve circled the most recent lows in the ratio. These are the “higher lows” I’m talking about. They whisper the market’s sentiment, which is that discretionary stocks are beating staples… so the market is strong.
I’m still waiting to see higher highs in the ratio, which will further confirm the market’s strength. But for now, this very useful indicator is suggesting the market still has legs to run higher.