Relative Strength of Discretionary to Staples XLY to XLP

Jan 22, 2009: 10:59 AM CST

Often it can be helpful to analyze relative strength charts of key stocks or sectors to get hidden insights into possible future price moves or current structure.  Analysts often use the ratio of the Consumer Discretionary Sector (XLY) to the Consumer Staples (XLP).  Let’s see what this might mean and where this ratio is currently.

First, a little background.

If you can subdivide all stocks into two broad categories, they might be ‘stocks that do well in rising markets’ and ‘stocks that hold up better in bear markets.’  That’s what we’re trying to assess by looking at the Discretionary Sector, which includes retail, entertainment, gaming and stocks of companies that tend to do well when we all feel optimistic about the economy and thus are willing to spend money freely.

On the contrary, ‘Defensive’ stocks or “Staples” refer to products/services from companies that we cannot do without no matter how bad the economy is.  Think of the things you do on a daily or weekly basis:  brush your teeth, wash your clothes, eat food, drink beverages, etc.  Companies that produce these goods might not be as interesting as a tech stock, but generally their stocks will show less volatility and will ‘hold up better’ than retail or other stocks of companies we can cut back on their products if needed.

It’s under that theory that we can assess sentiment by comparing the ratio of the Discretionary Sector to the Staples Sector.  If the ratio is rising, Discretionary stocks are outperforming Staples and we would expect a risk-taking, optimistic environment.  However, when the ratio line is falling, that is often a sign of pessimism or economic tightening which is what we’re seeing now.

Let’s look at the Weekly Relative Strength ratio and then compare it to the S&P 500 (gray line):

The red and black line represents the Relative Strength Ratio.  The ratio peaked in early 2007 well ahead of the actual S&P 500 peak in October.  In fact, as the S&P 500 made a new October 2007 high, the XLY:XLP was making a new low which was a hidden non-confirmation.  The ratio line fell hard into 2008, stabalized through the first half of 08, then collapsed along with the market in October into new lows in November 2008.

There is no evidence of recovery or hidden strength in the ratio line at the moment.  Often simple trendline analysis is sufficient to detect clues in relative strength charts.

Now let’s look just at the relative strength chart with classic technical analysis:

I’m showing the ratio line going back to the beginning of 2007.  The ratio broke its key moving averages and they turned bearish around September 2007 before it failed to break above the 20 and the ratio fell quickly into 2008.  We were never above to breach the falling 20 day EMA on any meaningful basis and that’s where we stand now – the ratio has found resistance after a swing-up into the falling 20 EMA.

Looking at this ratio closely can be one way to get an early jump on the market, as can be watching the XLF Financial Sector SPDR.  Keep your eyes fixed on these two critical puzzles which need to be bullish or at least show initial strength before we can expect any meaningful recovering in the US Equity Indexes.

Corey Rosenbloom
Afraid to Trade.com

11 Comments

11 Responses to “Relative Strength of Discretionary to Staples XLY to XLP”

  1. Gawed Says:

    a good place to see what relative strength is? I first thought you were talking about RSI but nope. this poor rookie got punk’d! lol

  2. Corey Rosenbloom Says:

    haha Yes, BIG difference. The RSI is an indicator which compares price today with price in the past in a range, but the concept of Relative Strength compares one market to another or one stock to a market to see which is outperforming the other. It’s mainly tied into asset allocation and sector rotation strategies.

  3. DaveB Says:

    Excellent post. I never would have thought to look at something like this. This ratio may evnetually provide an early hint of a turnaround – it’s definitely on my watch list. Thanks!

  4. Corey Rosenbloom Says:

    Thanks Dave.

    I feel like I’m giving away too many secrets here!

  5. Anonymous Says:

    Keep your eyes fixed on these two critical puzzles which need to be bearish or at least show initial strength …

    Did you actually mean “… need to be bullish …”?

  6. Corey Rosenbloom Says:

    Anon,

    Good catch! Thank you for letting me know. I’ve made the correction.

  7. DaveB Says:

    Heh, well for the sake of rookie traders like me I hope you’ll keep giving away secrets for a little while longer! I’m learning a lot from this blog. 😉

  8. Manju Shekhar Says:

    Corey, nice analysis. Thanks for alerting us to this kind of technical analysis.

  9. NotAfraidofTrend Says:

    Corey, Thanks for a good Relative Strength analysis of discretionary vs defensive sectors. There are many other relative strength indicators relating to market internals that are also used by a lot of people as leading indicators. Confirmation by various inter-market and intra-market indicators is always helpful. However, for short-term trading, I wonder if these indicators work consistently, as the market also keeps changing its character. Only some of the fundamental attributes of human behavior are more constant and these fundamental attributes of human behavior are consistently captured by Elliott Waves and they have also stood the test of time.

    Besides defensive sectors, there are also some defensive stocks like Exxon and Walmart. But, as per Jim Cramer, there is no place to hide and even the defensive stocks will eventually get hit before we could possibly think that the market has bottomed.

  10. Corey Rosenbloom Says:

    Thanks Manju! I have to remind myself to look at things like this from time to time.

  11. Corey Rosenbloom Says:

    NotAfraid,

    I try to scan charts of the breadth, new highs/lows, etc but it doesn’t come naturally to me – but it’s very important.

    I don’t know about the consistency of these indicators short-term. I have them on my charts but I certainly don’t make trading decisions based off them. If there’s a major red-flag, I might *not* take a trade but I haven’t tested them or traded extensively off intraday internal indicators.

    Yes, Cramer has that right. Even though a relative strength line might be rising, it doesn’t mean the stronger stock is rising. If stock ABC fell $5 in the same month stock XYZ fell $10, ABC would show massive relative strength to XYZ but it still lost $5.