Thinking In Themes: What Color Are Your Markets?

Themes give the stock market color; they capture the movement of capital from certain sectors of the economy to others. Many traders are color-blind. They fail to detect the themes underlying market moves and, as a result, fail to understand *why* those moves are occurring.

A great example of color blindness came in 2000-2001 when the technology stocks, which had been furious leaders of the rally from the late 1990s to March, 2000, began underperforming large cap Dow stocks. Traders who understood this as a movement toward safety--away from growth and risk and toward stable blue chips--weathered the subsequent bear market far better than those who color-blindly stuck with the NASDAQ all the way down.

Permabears are another great example of color blindness. They see one kind of market, heedless of the themes underneath the movements of the averages.

Note from the chart above (click to enlarge) that, as the broad market (SPY) has been in decline since mid-2007, the relative strength of consumer discretionary stocks (XLY) to consumer staples stocks (XLP) was also on the decline. This makes sense: in the face of recessionary fears, investors move away from companies dependent upon consumer spending and toward defensive names that will sustain revenues even in a bad economy.

Note, however, that, as SPY made new price lows in March relative to January, the relative strength of XLY to XLP did not follow suit. Now SPY is breaking to multimonth price highs (and is less than 10% off its bull market highs) and the XLY:XLP relationship is moving higher as well. Similarly, we're seeing some recent relative strength of financial stocks (XLF) to materials stocks (XLB), as investors shift money out of commodity-related areas and into beaten-down bank shares.

Make note: It's not just that the stock market is holding its own that is significant; it's that the themes that underpinned the market decline are being unwound. In other words, it's not just the market move that's important; it's also the reasons why the market is moving.

Gradually, but unmistakably, money has been flowing back into high yield bonds. Money has been flowing back into financials. Money has been flowing back into consumer discretionary shares. Money has been flowing into the U.S. dollar. We have been seeing a drying up of risk aversion and a pick up in risk-seeking trades. Slowly, we are seeing a willingness to own financial assets over hard commodities.

That's the color of the current market.
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Comments

[CloroxCowboy]

I'd be interested to know how many investors not suffering from color-blindness in 2000 were called perma-bears at the time? From what I remember, the concensus (among the vast majority) then was that we had reached a paradigm-shift in market behavior - earnings no longer mattered, etc...

Also I'm not sure that the XLY:XLP ratio means that consumers are actually changing their spending habits? With the current prices of oil and food, those indices appear to be speculation-driven as more and more Americans are thinking of ways to cut back on their discretionary spending, not increase it.

Bottom line, investors may be able to move ratios around, but they can't turn a slowing economy into a rallying one for very long if/when consumers stop spending.

[billddrummer]

If in fact money is moving slowly back into consumer discretionary stocks, then the worst of the economic contraction may be over. If, on the other hand, the movement represents a profit-taking exercise and discretionary spending continues to fall, with negative earnings surprises in the 2nd quarter from consumer discretionary companies, money may move back to consumer staples with a vengeance.

[zenalgorithm]

We have just completed phase 1 of this recession: financial calamity, stocks fall, FED lowers rates, and commodities rise.

Phase 2 will go like this: Media cheerleaders say there isn't even a recession going on - citing government #s, stocks rally, numerous threats that the FED will actually start to raise rates in just a few months to combat inflation, commodities fall, retail #s get really bad, stocks fall hard again. FED lowers rates again. "...The end is coming..."

Phase 3: Housing stops falling, U.S. pulls troops out of Iraq, balanced budget, market goes up.

Red>purple>green...

[paulibloom]

Amazing how people react to the actions of thousands of participants and billion of dollars by putting in their own views. What silliness. The author took the perspective of not giving his own personal view but rather an analysis's what the market might be saying. The response is personal opinions which we all have which are frankly of little or no value. How funny.

[TradingSystemReviews]

The other thing to consider is that while bull markets are never a smooth flow upwards, they go in legs (many people far smarter than I have explained why this happens in many ways) The same is true of bear markets, so you have to also consider that this is simply the first leg of a bear market. It could be construed that what we are seeing is the first tentative steps back into the financials and consumer discretionary and if there are any mis-steps along the way, it will bolt for safer waters. Or it could be exactly as described above, 'a drying up of risk aversion'. To me the chart above really isn't very conclusive as yet.
To paraphrase one wise trend follower - you can keep the first and last 25% of any movement, give me the safe 50% in the middle - and right now this looks far too 25% for me.....

[syndicat]

There is a saying that growth investors sell too late (tech: 2001-2003) and value investors buy too soon (financials/consumer discretionary: 2008)