Two Stock Market Sector Ratios Worth Watching Closely

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The above charts represent price ratios between pairs of sector ETFs within the S&P 500 universe. Each represents a theme that I consider to be a driver of the recent bear market. Accordingly, I am watching these ratios (and themes) for indications of a continuation vs. reversal of bear market dynamics.

The first theme (top chart) represents the price ratio between the Materials ETF (XLB) and the Financials ETF (XLF). It depicts the relative valuation of physical assets--raw materials--to financial assets. In a weak dollar environment, as well as an environment of low confidence in the banking sector, raw materials should be more attractive than financials. A reversal of this ratio would suggest that the dynamics underpinning the weak dollar (expectations of further interest rate cuts by the Fed; lack of G-7 action toward a stronger dollar; recessionary expectations; fear of bank failures) were shifting.

The second theme (bottom chart) represents the price ratio between the Consumer Staples ETF (XLP) and the Consumer Discretionary ETF (XLY). It depicts the relative valuation of defensive stocks--those traditionally deemed relatively recession-proof--vs. those that are more vulnerable to contractions in consumer spending. In a recessionary environment, Staples should outperform Discretionaries as investors flee to sectors representing relative safety. A reversal of this ratio would suggest that the dynamics underpinning the recession (weak housing market; weak consumer confidence; weak employment market) were shifting.

What we see clearly in both charts is that, since mid-2007 (the period recently highlighted as one of changing intermarket dynamics), these ratios accelerated significantly as the stock market sold off. The XLB:XLF ratio topped out in mid-March (when the stock market made its price lows), pulled back sharply, and has since been clawing its way back toward its highs as stocks have fallen back. The XLP:XLY ratio topped out in early January (when the number of stocks making new 52-week lows maxed out), dropped back sharply, and has bounced back in a choppy manner since then.

Both of these ratios capture something of the psychology of the current stock market. A move to new highs would suggest that the psychological drivers of the recent bear market are intact. A failure to advance to new highs, even as the number of stocks registering fresh 52-week lows is dwindling, would have me questioning the bear's longevity.

Comments

[OverTheHill]

It would be interesting to see these two plots overlaid with the Dow and S&P back to 2000/01 timeframe to see the coorelation of movements between the ratios and these two key indices.

[Hilarius]

That is a fascinating article

The depressing aspect is that a return to confidence in financials seems necessary for a significant market recovery

It seems curious that we need an upgrading of paper shuffling stocks (banks & financials) to signal the return to a bull market

I would have thought greater concentration on materials and energy stocks would have been a sign of market maturity v the insanity of the paper shufflers in recent times

I understand the point he is making ... that the paper shufflers have lost credibility ... and that they need to regain some

How they do that without crucifying their customers and the economy will be interesting to see

When the Bank of England lowers its rate the mad buggers in the City of London ... the so called respectable banks ... are raising theirs

In the meantime I hope that there won't have to be a collapse in commodity prices to bring about Mr Steenberger's "recovery"

It is hard to see how a loss of confidence in materials would denote an end to bearish sentiment

So maybe we have to cross our fingers that materials and energy will continue to improve but paper shufflers will improve faster (unlikely?)

I suppose I do prefer a bank which keeps its doors open to one that closes down, but I think bank shares were grossly over-priced

This seems to me to be the correction we had to have ... because the greed merchants had gone crazy

If we can get back to actually producing stuff that would be great

I think Mr Steenberger's Staples v Discretionary comparison makes much more sense but reveals an unattractive aspect of Western living

We all need to get back to buying non-essentials so that the money merchants and the whole economy can thrive again ..... ???

The idea of producing stuff that really matters seems to escape people

I continue to believe that the West is decadent and needs a great deal more productive vision ... eg Agricultural stocks & cheaper cleaner Materials and Energy

With Best Wishes

Hilarius