Introduction to Relative Strength Part 3In parts one and two (linked) we discussed the construction and use of relative strength ratios (RS) in trading and analysis, common errors, and best practice. In part three we look at the consumer discretionary to consumer staples ratio and attempt to draw trading and economic insight from that analysis.
Any method used to analyze a single security price chart can be used to analyze ratios. I tend to use simple methods and I do not require the same precision in terms of retracements and support/resistance that I would use when analyzing or trading a single security.
Consumer Discretionary (XLY) / Consumer Staples (XLP):
I generally think about this ratio in two ways. The first, and for my purposes, the most important, it reflects the markets judgement around the strength of the economy. When the economy is improving, as it has over the last few months, the ratio should weaken (which it has done). This is because as discretionary income rises, confident consumers are more likely to spend on non-essentials or staples. When they are less confident, they spend less on non-essential discretionary and more on staples. It is important to remember that consumption is around 70% of GDP. For economic or macro analysis, I prefer to use monthly perspective charts.
I believe that the long outperformance of discretionary relative to staples is mostly due to the massive liquidity added to the system since the great financial crisis. The liquidity that has aided consumers and thus the economy in general. As liquidity normalizes and the economy slows, staples should begin to outperform discretionary.
The second is creating a tradable spread. Creating proportional spreads (see part two) between two sector ETF's, expressing trades that overweight or underweight specific sectors inside a portfolio, or creating pairs trades using names within the two sectors are all legitimate uses of ratios. When creating pairs trades inside a sector my preference is to use each sectors market largest capitalization names (market generals) as they are less vulnerable to idiosyncratic risk. I also prefer to pair names with similar businesses. For instance, I would not pair Walmart (staples) with Tesla (discretionarily) but would consider Walmart or Costco verses Amazon.
One final thought, profitable spread trades can be structured using either highly positive or negatively correlated pairs. What fails to work consistently are spreads with spurious correlation.
Chart 1 TOP: Monthly Consumer Discretionary (XLY) in ratio to Consumer Staples (XLP): Top Panel: Close line charts for both ETFs.
Since XLY on the left scale trades at over two times the price level of XLP (172 verses 72), XLP has been compressed in order to easily compare the paths of the two symbols. Clearly both staples and discretionary have significant positive long-term correlation as they follow the larger market higher and lower. The high degree of correlation suggests that the two markets can be generally expected to trend together, but at varying rates depending on the consumer/economic outlook. It is the difference in the rates of change that creates the profit or loss.
Monthly: Technically, the ratio topped in October 2008 and since 2011 has trended lower in a well-defined channel. That channel was broken in March 2022 as inflation exploded higher and the Federal Reserve began to tighten monetary policy (both actions hurt discretionary spending).
Over the last few months, as the outlook improved and the economic narrative changed to soft landing, the ratio has again turned lower and is now testing the area of the broken trendline that defined the broad down sloping channel.
MACD momentum remains on a sell signal. In this perspective, I view the chart at an important juncture from which a sign of either strength or weakness is likely to define the trend for the next year.
Weekly Detail: Note the narrow Bollinger band and the turn higher over the last few weeks. A break above the lateral resistance coupled with a break of the downtrend would strongly suggest that staples are likely to outperform over coming months.
As a last step, I like to examine the raw bar charts on both sides of the spread. In this case, like the general market, both look weak. Discretionary is retreating from the top of its range while staples are resting at good support. The concern here would be that a breakdown from a long range of distribution would likely generate significant selling and imply significantly lower lows.
Conclusion: I suspect that the spread is in the process of bottoming and that, as the economy weakens over the next few months, staples will outperform. But, overt proof of a turn higher is lacking. While the recent hook higher is promising, it needs to move above the overhead resistance. If it does, odds become very good that the economy is weakening and that staples will enter a significant cycle of outperformance.
And finally, many of the topics and techniques discussed in this post are part of the CMT Associations Chartered Market Technician’s curriculum.
Good Trading:
Stewart Taylor, CMT
Chartered Market Technician
Taylor Financial Communications
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