One of our favorite ways to gauge whether we are in an expansion phase or a contraction phase is to compare two sectors against each other: consumer discretionary and consumer staples.

Consumer discretionary stocks represent those companies — like Walt Disney Co (NYSE:DIS), Home Depot Inc (NYSE:HD) and Nike Inc (NYSE:NKE) — that tend to do better when consumers have extra money to spend and enough confidence in their economic future to spend it.

Consumer staples stocks represent those companies — like Procter & Gamble Co (NYSE:PG), Philip Morris International Inc. (NYSE:PM) and Walmart Inc (NYSE:WMT) — that tend to do well even during economic downturns because people tend to continue buying soap, cigarettes and general supplies even when the economy stinks.

As you can see in Fig. 1, consumer discretionary (Stage 2) and consumer staples (Stage 5) are at opposite ends of the business cycle.

Fig. 1 — Sector Rotation during the Business Cycle

Consumer discretionary stocks start to outperform near the bottom of the business cycle, and consumer staples stocks start to outperform near the top of the business cycle.

This tells us that when consumer discretionary stocks are taking the lead, we can be fairly confident that traders believe both the economy and the stock market are doing well. It also tells us that when consumer staples stocks are taking the lead, we can be fairly confident that both the economy and the stock market are doing poorly.

One of the reasons this is a favorite gauge of ours is that it is quite easy to compare these two sectors. All you have to do is create a relative strength chart of the Consumer Discretionary Select Sector SPDR Fund (NYSEARCA:XLY) and the Consumer Staples Select Sector SPDR Fund (NYSEARCA:XLP).

When the relative strength chart is moving higher, it tells you that XLY is outperforming XLP. Conversely, when the relative strength chart is moving lower, it tells you that XLY is underperforming XLP.

As you can see in Fig. 2, XLY has been consistently outperforming XLP since Labor Day 2017, signifying expected strength in the economy.

Fig. 2 — Relative Strength Chart Comparing XLY and XLP

However, for the past few weeks, XLY has been losing ground to XLP, and the relative strength chart has started shifting lower.

As you can see in Fig. 3, if XLY continues to lose strength, the relative strength chart will likely form a “head-and-shoulders” bearish reversal pattern.

Fig. 3 — Relative Strength Chart Comparing XLY and XLP with Potential Head-and-Shoulders

This classic reversal pattern, if completed, would signal that the market is in for a significant pullback during the coming months.

However, price patterns are only considered valid once they have been completed, and the potential head-and-shoulders pattern in Fig. 3 is still just that…only a potential pattern.

If the trade-war rhetoric between the United States and China can continue to deescalate, and if the major financial institutions — JPMorgan Chase & Co. (NYSE:JPM), Wells Fargo & Co (NYSE:WFC) and Citigroup Inc (NYSE:C) — can kick earnings season off with a bang on Friday, the XLY/XLP relative strength chart could rebound and look more like Fig. 4 below.

Fig. 4 — Relative Strength Chart Comparing XLY and XLP with Potential Rebound

As you can see, the bearish future for stocks has not been set in stone, but the market is at an important inflection point.

The Bottom Line

We believe that traders on Wall Street want to be bullish, but they have been thwarted in their desire to buy and push prices higher by the uncertainty coming out of the White House. If, however, they can find any excuse to rotate back into aggressive equities, we believe that they will.

You can learn more about identifying price patterns and using them to project how far you think a stock is going to move in our Advanced Technical Analysis Program.

InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.