Let's think through the relative strength relationship between Consumer Discretionary (NYSEARCA:XLY) stocks and Consumer Staples (NYSEARCA:XLP) shares. When traders and investors anticipate economic growth, they are more likely to favor Consumer Discretionary shares, as these will see increased demand. Conversely, if market participants anticipate recession, they will tend to favor the Staples companies that can hold up their sales even during economic retrenchment.
Above, we see the S&P 500 Index (SPY; blue line) plotted against the relative strength relationship between XLY and XLP (pink line; 6/1/2009 = 100). We can see that the relative strength between the two consumer ETFs has tracked strength in SPY throughout this bull market, as economic growth assumptions have led investors to buy U.S. stocks.
We can view this relative strength relationship as a kind of longer-term sentiment measure, rather than as a short-term timing tool. As long as SPY is making new highs and XLY is continuing to outperform XLP, we can infer that investors' favorable economic expectations remain intact. When XLY underperforms relative to XLP even as SPY remains at or near highs, we can infer that investors are anticipating economic weakness. This occurred during 2007, when XLY/XLP topped out well ahead of the large cap indexes.
If you look historically, you'll also see that XLY/XLP bottomed ahead of SPY during the late 2008/early 2009 market lows.
In upcoming posts, I will take a look at other ETF pairs and how these might serve as sentiment gauges. For more, see Sector Relationships and Sentiment.