What are Discretionary vs Staples Telling us?

This is an important one that we haven’t discussed here in a while. Today we’re looking at the Consumer Discretionary space relative to Consumer Staples. When the economy is kicking and money managers are optimistic, money is going to flow into discretionaries at a faster rate than into Staples, which tend to be more defensive.

Think about it, even if the economy stinks, we’re still going to brush our teeth, wash our dishes, drink beers and smoke cigarettes. That won’t change. These are the kind of companies listed under Staples: Procter & Gamble, Philip Morris, Colgate-Palmolive, etc. In the discretionary space you’re looking at retailers, auto companies and other places where we spend our “discretionary” income. Companies like Amazon, Disney and Ford are all good examples.

This is why the chart comparing these two sectors is so important to us: the $XLY/$XLP ratio. We look to this one as a leading indicator for the overall market. You can see how this one peaked in early 2007 and failed to make a new high before the overall market topped and crashed. Then at the bottom, the discretionary/staples ratio bottomed in November, well before the overall market did the following March. Although S&Ps were still making new lows, the positive sector rotation was already pointing to a bottom:

2-24-14 xly vs xlp

You can see this chart is now breaking out to new all-time highs to start the year. It’s hard not to take that as a big positive for the overall health of the US stock market. Back in May, one of the reasons I was so bullish on US equities was because this ratio was in the process of breaking out of a multi-year range.

So we want to keep a close eye on this chart. As long as prices can stay above those previous all-time highs, we have to continue to give the bulls the benefit of the doubt from a structural perspective. At times I may or may not get bearish over the short-term, but structurally there is nothing wrong with this market and I believe this ratio confirms that.

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