History can be an excellent guide for spotting major turns in the market. Naturally, the market and indicator levels we saw in 2006 and 2007 are firmly etched on our charts, now serving as key levels to watch.
Yet, timing the next market crash isn’t as simple as watching the 2007 levels and taking action as soon as they’re reached. As Mark Twain put it: “History doesn’t repeat itself, but it does rhyme.”
Here’s a chart I’ve shared before. It’s the ratio of consumer discretionary (XLY) stocks to consumer staples (XLP) stocks.
This ratio is generally viewed as a bullish indicator when it’s rising and a bearish indicator when it’s falling. The rationale for that interpretation is simple.
Consumer discretionary stocks typically outperform consumer staples stocks when investors are confident and bullish. That’s because consumers buy more discretionary items when they’re confident that the economy is healthy and growing and when they have extra cash in their pockets.
Investors, too, buy more consumer discretionary stocks when they’re confident and bullish, as these stocks typically provide bigger gains than consumer staples stocks.
What’s interesting about the period between 2004 and 2007 is that the discretionary-to-staples ratio moved mostly sideways. And this occurred during a time when homebuyers were using home equity lines of credit (HELOCs), like “free-money ATMs,” as the paper value of homes rose sharply prior to 2007. So, while consumers were indeed spending lots of money on discretionary items, investors weren’t buying discretionary stocks as aggressively as one would have expected.
Fast-forward to today and you’ll see the discretionary-to-staples ratio is still climbing sharply, instead of making the long sideways move we saw between 2004 and 2007. We’ve now surpassed the ratio level that represented the 2007 peak; however, the ratio is showing no signs of turning downward.
What does that mean to us as investors?
It means we should remain cautious, as the ratio is now higher than it’s ever been. But at the same time, it’s too early to call an imminent top. Instead, we should wait to see the discretionary-to-staples ratio falter first, moving sideways and then eventually trending lower. Once that happens, it will be a very ominous warning that stocks are setting up for a crash. Stay tuned.