- Price ratio indicators cut out market noise and can be used to indicate underlying economic trends.
- By dividing the price of consumer discretionary stocks by consumer staples stocks, you can generate a leading market indicator that highlights consumer spending trends.
- By dividing industrial stock prices by utility stock prices, you can get a leading manufacturing growth indicator.
- Overall, these indicators suggest we may be headed for a longer bear market.
- Looking for a helping hand in the market? Members of Core-Satellite Dossier get exclusive ideas and guidance to navigate any climate. Get started today »
If you're a reader of my articles, you may know that I employ ratio analysis as a cornerstone tool for my technical framework. I believe price ratios are extremely useful in assessing underlying market trends as a means of filtering out the noise and finding the truth.
Simply by dividing the total returns of one asset by a related asset, we can remove this noise. One well-known price ratio is the gold-to-silver ratio which tells us about the relative performance of gold compared to that of silver. By dividing the two, the noise relating to "precious metals" as a group is removed, and we get a more clear technical signal.
This is illustrated below:
As you can see, these two charts are nearly the same, and we cannot clearly see which metal will be favored by the market. However, by dividing the two, we can see that a clear linear trend in favor of gold that is now making a double top:
While GLD has had a nearly linear outperformance pattern to SLV, that does not mean it will continue. In fact, it may mean the opposite. As you can see, the ratio recently surpassed its past peak and is making an exponential move higher much like a "blow-off-top" pattern. This may mean more outperformance of gold in the short-run, but in the long-run, it usually is a sign of a peak marked by capitulation by some investors (in this case, silver investors).
There is a mathematical reason why this method is so useful. Let's say:
- (percent change of gold) = percent change of precious metals + unique percent change in gold.
- (percent change of silver) = percent change of precious metals + unique percent change in silver.
Further, some simple calculus tells us that:
- Percent change in gold/silver ratio = percent change in gold - percent change in silver.
- Percent change in gold/silver ratio = unique percent change in gold - unique percent change in silver.
What makes gold unique to silver? Less economic exposure and generally greater monetary acceptance. Silver is also more abundant, so miners can change production to meet demand more easily if capital is available to do so. So, the gold/silver indicator can be used as a positive economic indicator of supply-side (i.e. physical production) growth.
The gold/silver ratio is the most common of these ratios, but there are many more that are likely far more useful for investors. I firmly believe that the market is the best leading economic indicator, but investors must know how to best use market data. I'd like to propose a few price ratio indicators I use and explain what they're telling us about the market today.
The Consumer Discretionary-to-Staples Ratio
Consumer Discretionary (XLY) and Consumer Staples (XLP) are related sectors in that they share similar supply-chains (from production to the store), but discretionary stocks generally carry more exposure to consumer spending than the more "bread-and-butter" staples. Thus, the ratio of XLY/XLP can tell us about the market's belief regarding future consumer spending. The higher the ratio, the more bullish is the market about consumer spending.
Take a look below:
To prove how useful this ratio is, see how it led the S&P 500 in both the 2000 and 2008 bear markets (particularly, 2008):
As you can see, the XLY/XLP ratio started dropping about six months before the S&P 500 in 2007 and made a more clear top early in 2000. Further, the ratio has been in decline since the very end of 2018 and has flattened out since with strong support around 1.9. If the ratio breaks 1.9 to the downside, it would likely imply the S&P 500 is headed quite a bit lower.
The Industrial-to-Utilities Ratio
A similar leading economic indicator can be found by dividing the price of industrial stocks (XLI) to utility stocks (XLU). Both have very high physical capital costs and share many supply-side economic characteristics, but demand for utilities is nearly constant, while demand for industrial products is very cyclical.
As you can see, this ratio gives us a "live" proxy for the U.S. manufacturing PMI, which is generally regarded as a leading economic growth indicator:
As you can see, the two are highly correlated, and sometimes, one leads the other. In this sense, it is "coincidental" to the leading manufacturing indicator, but it is superior because it is updated by the second and not the month.
A similar leading indicator can be found using the transportation ETF (IYT)
The Bottom Line
This is a basic introduction to a very useful method for analyzing what is going on "beneath the surface" of the market. In this article, I stuck with the most straight-forward cyclical ratio indicators though the method also works for secular indicators (i.e. long-term economic trends benefiting healthcare stocks by using XLV/SPY).
Overall, these indicators are generally bearish on the U.S economy and indicate that manufacturing is likely to continue to slow down and consumer spending likely to fall soon.
After falling 10%, the stock market is officially in a correction and may continue lower. Personally, I'd be surprised if dip-buyers and Fed dovishness give the market at least a short-term bid to stop the bleeding, but the ratios suggest we are toward the end of the economic cycle.
In the coming days, I'll publish another article like this that covers how ratios can be used for international asset allocation and to find long-term trends (i.e. growth vs. value). Feel free to follow my account if you'd like to stay in the loop.
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