Since putting up a few ratio charts recently, Silver vs Gold and Small-Caps vs Large-Caps, I have been asked several times about what other ratios I look at to help determine the direction of the overall market. This is a tough business so I look for any clue that will help me manage my risk and warn me of a deteriorating market. A ratio that I think deserves some attention right now is: Discretionaries vs Staples ($XLY:$XLP)
If times are good and consumers have more Discretionary income to spend, they are more inclined to go out to eat, take their kids to Disney World, order items at online retailers, buy new cars, and do some home improvements. $XLY is the Consumer Discretionary Sector Fund so it owns companies like Walt Disney ($DIS), Amazon ($AMZN), Ford ($F), and Home Depot ($HD). These are companies that are more sensitive to the economic cycle. So much so that the group is often referred to as Consumer Cyclicals.
Economic times may not always be so rosy, but consumers are still going to be shaving, smoking cigarettes, drinking sodas and buying medicine. $XLP is the Consumer Staples Sector Fund so it owns companies like Proctor & Gamble ($PG), Phillip Morris ($PM), Coca-cola ($KO), Walgreens ($WAG) and $CVS. This group of stocks is impacted less by the ups and downs of the economy, so they act more defensive in a portfolio. Remember that Defense wins championships.
Here is the chart of the ratio in Red with the S&P500 behind it. Don’t they flow together nicely? It’s easy to see that when money is flowing into the stock market, this ratio is confirming that market participants are encouraged about the economy.
If we take a closer look, it appears there is a little bit of a divergence currently going on. As the S&P500 is up against February highs and attempting to break out, the ($XLY:$XLP) ratio is no where near the high and barely holding on to support. This is something that we want to play close attention to over the next week or so.
**UPDATED: AFTER THE CLOSE 4/11/11**
$XLY:$XLP breaks support on a closing basis. Let’s call Support around 1.29 and we closed at 1.285 – not good. S&P futures are down slightly after Alcoa’s top line miss ($AA). Let’s see what kind of follow through we see tomorrow on $XLY:$XLP. 1.275 is probably the last line of support here.