As consumers we’re rather predictable in our spending patterns because, frankly, we just NEED certain things. Try telling a teenage he can’t have his potato chips! He’d starve, right!?

And, although many consumers live simple, disciplined lives… everybody splurges on something they WANT now and again. Ice cream, anyone!?

When you look at it this way, there are really only two categories of consumer spending:

1) Discretionary – things we WANT, and
2) Staples – things we NEED.

Naturally, these two categories fight for the affection of each of our dollars. It’s like having two advisors – an angel and a devil – sitting on each shoulder as you walk through the shopping center. Who wins depends on who has the most convincing story… and the credit card.

A comparison of how consumers split their dollars between these two categories is instructive about the economy, in general…

In theory, higher levels of discretionary spending, relative to spending on staple goods, shows consumers have fatter pockets and a healthier outlook on the future.

As there are ETFs that track these consumer sectors, it’s easy to see where consumers are spending their money. It also shows which type of stocks investors are buying more aggressively. Take a look…

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The white bars show the S&P 500 since late 2011. The green line shows the ratio between the consumer discretionary (XLY) and consumer staples (XLP) sectors.

Right now, the XLY:XLP ratio is making higher highs, while the S&P 500 is still working to regain the last 1.5% of the 6.5% dip that began May 21.

Interestingly, this pattern – where the bullish XLY:XLP ratio leads the market out of a minor correction – emerged at the end of last year. Back then, as the ratio made new highs, confirming the underlying strength and confidence of the consumer, the S&P 500 was still about 2% shy of breaking above its own highs.

Eventually, the stock market caught up with the XLY:XLP ratio, which acted as a leading indicator of higher stock prices in early 2013.

Looking ahead, I expect to see the same result this time around. While we could still be a couple of weeks away from knowing for sure, I’m watching for the XLY:XLP ratio to continue higher, and to bring stock prices up with it.

Stay tuned…

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Adam O'Dell
Adam O'Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with the minimum risk. Adam has worked as a Prop Trader for a spot Forex firm. While there, he learned the fundamentals of trading in the world’s largest market. He excelled at trading the volatile currency markets by seeking out low-risk entry points for trades with high profit potential. An MBA graduate and Affiliate Member of the Market Technicians Association, Adam is a lifelong student of the markets. He is editor of our hugely successful trading service, Cycle 9 Alert.