Stocks have enjoyed a powerful rally off their summer lows, as bulls have been in control for about two months now.
A lot of technical damage has been repaired during this time.
The outlook from sentiment and seasonality assure us the environment is ripe for a bottom.
Breadth thrusts are stacking up and suggesting we could be in the early stages of a new bull market.
And risk appetite is gradually reentering the market, supporting the bullish price action.
Today, we'll review one of our favorite intermarket relationships, the discretionary versus staples ratio.
By comparing these two consumer segments, we garner valuable insights about the current market environment and risk appetite in particular.
Here's the large-cap Consumer Discretionary $XLY versus Consumer Staples $XLP ratio:
As you can see, XLY/XLP just reclaimed its 2018 highs after collapsing beneath this key level earlier in the year.
This prior-cycle peak represents where risk assets topped out and rolled over during the last bull run, making it a critical level of interest for global markets.
How prices react from here will provide us with excellent information about how investors are positioning themselves into the back half of the year.
More importantly, this will give us a signal as to the sustainability of the current rally.
If investors begin to favor staples and XLY/XLP fails to hold onto those 2018 highs, stocks are probably rolling over too. It’s that simple.
Just look at how closely this ratio moves with the broader market over time:
Bulls want to see the ratio hold on at this key level and make a sustained upside resolution. This would be a constructive development and would increase our conviction that the bottom is in for stocks.
Following a significant market bottom, it is common to see higher beta and risk-on areas outperform. That’s been the case for the past month and a half, as evidenced by the rally in XLY/XLP.
The question now is, will it continue?
If it doesn't, and XLY/XLP is rejected here, it would tell us that investors are reducing their exposure to risk and adopting a more defensive posture. This isn’t the kind of behavior we tend to see in the early stages of a new bull market.
Under this scenario, we'd expect the broader market to lose steam and come under pressure.
The 2018 high around 2.20 in XLY/XLP is the level we’re watching when it comes to risk appetite.
If we’re above there, we’re on offense and looking for stocks to buy.
If we’re not, it’s probably time to bring the defense back onto the field.
With the market finally correcting some following the recent run-up, we should have our answer soon.
Let us know what you think, and as always, please reach out with any questions.
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