Thursday, June 03, 2010

An Important Ratio For Stock Investors To Follow


Above is a 4 year weekly chart of the S&P500 and in the lower panel is a ratio of consumer staples vs. consumer discretionary stocks. A rising ratio line means that consumer discretionary stocks are outperforming consumer staples and is considered bullish for the stock market.. A falling ratio line would mean that discretionary stocks are under performing consumer staples and is considered bearish for the stock market. The way I use the spread is to look for divergences.

Let's walk through the above chart slowly so that we can see how well this ratio acted as a leading indicator for stocks. In the summer of 2007, the stock market was making new highs but the ratio line did not make a new high which sets up a bearish divergence. As you can see the stocks market subsequently sold off.

In may of 2008,  stocks made a new high for the year but the ratio did not which set up a bearish divergence. Well needless to say, stocks literally fell out of bed.

In March 2009, the stock market made new lows for the year but the ratio did not which created a bullish divergence. Well that divergence kicked off a 13 month rally.

In October 2009 the ratio diverged from the stock market and gave a false sell signal. Hey, nothing is perfect.

So that brings us to where we are now. Just last week the stock market broke low for the year but the ratio line is diverging substantially.  This sets up a bullish divergence and suggests that we will see higher stock prices in the weeks to come in my opinion.  Keep in mind, we also have that 3 1/2-month-cycle that I've written about last week which is calling for a bottom around this time.

As you can see, the pieces of the puzzle are beginning to come together which in my opinion is suggesting that we are in a bottoming process and that we should be looking to accumulate stocks.. If we do rally, nobody can say for sure what the magnitude of the rally is going to be. It might be a dead cat bounce or an explosive rally. In any event, I'm looking for higher stocks prices in the weeks to come.

5 comments:

Anonymous said...

Kevin,

Has the TLT:SPY ratio tilted back in favor of stocks instead of bonds? You had shown this key chart last month and it was a very good predictor of the market's correction. Thanks.

-traderwannabe

Kevin said...

The spread is pulling back in favor of stocks..

Anonymous said...

Strong work. Impressive.
I agree. Lots of [dumb] money parked in cash, gold, and especially bonds.
Anything else should be good, unless euro crashes again and we have another crash like 2008. We should know soon. The euro is just about to complete it's triangle very soon.
Jack

Anonymous said...

I don't like the euro action today in the view of my comment last night.
Jack

Anonymous said...

I use a similar chart following retail stocks (XRT). Retail are getting pummeled lately, not a good sign for a rally. XRT can be considered a leading indicator. When you put a chart up showing its relative strength with the SP500, it is now falling much faster than the market. So we have 2 similar charts showing exactly the opposite conclusion. I say we are headed lower.
http://stockcharts.com/h-sc/ui?s=XRT&p=D&yr=0&mn=9&dy=0&id=p67394032156

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