When the S&P 500 hit its low on March 23 and started to rebound, traders around the world were wondering if the move was the beginning of a new bullish uptrend or just a “dead cat bounce” — where stocks would rise for a little bit, get everyone’s hopes up and then turn right back around and resume their downtrend.
We have confirmed the bullish rebound we’ve been experiencing for the past two months is not a “dead cat bounce.”
But how much longer are stocks likely to continue moving higher?
According to two of our favorite relative-strength charts, this move has an excellent chance of continuing into the summer.
Gauging Sentiment With Relative Strength Charts
One of our favorite methods to gauge whether bullish sentiment is getting stronger or is starting to fade is to create a relative-strength chart comparing the two consumer-based stock sectors against each other: consumer discretionary and consumer staples.
This method is especially useful during this period of high unemployment and pessimistic consumer sentiment.
Consumer discretionary stocks represent companies that tend to do better when consumers have extra money to spend and enough confidence in their economic future to spend it. Think of companies like Amazon (NASDAQ:AMZN), Home Depot (NYSE:HD) and McDonald’s (NYSE:MCD).
Consumer staples stocks represent those companies that tend to do well even during economic downturns. Companies like Procter & Gamble (NYSE:PG), Coca-Cola (NYSE:KO) and Walmart (NYSE:WMT) tend to do well during tough times because people continue buying shampoo, Coke and general supplies even when the economy stinks.
As you can see in Fig. 1 — a chart that shows which stock sectors tend to outperform during various stages of the business cycle — consumer discretionary (Stage 2) and consumer staples (Stage 5) are at opposite ends of the cycle.
Fig. 1 — Sector Rotation During the Business Cycle
Consumer discretionary stocks typically start to outperform near the bottom of the business cycle when the economy is shifting from its contraction to its expansion phase.
Consumer staples stocks typically start to outperform near the top of the business cycle when the economy is shifting from its expansion phase to its contraction phase.
By comparing these two stock sectors, we can see whether Wall Street is preparing for continued expansion or continued contraction.
When consumer discretionary stocks are taking the lead, we can be increasingly confident that traders believe both the economy and the stock market are going to be doing well in the future.
When consumer staples stocks are taking the lead, we can be increasingly confident that traders believe both the economy and the stock market are going to be doing poorly.
Consumer Discretionary vs. Consumer Staples
The simplest way to compare the performance of these two sectors is by creating a relative-strength chart of the Consumer Discretionary Select Sector SPDR Fund (NYSEARCA:XLY) and the Consumer Staples Select Sector SPDR Fund (NYSEARCA:XLP), where XLY is the first exchange-traded fund (ETF) in the pairing and XLP is the second (XLY/XLP).
When the XLY/XLP relative-strength chart is moving higher, it tells you that XLY is outperforming XLP. At this time, the S&P 500 is likely going to be doing well.
Conversely, when the XLY/XLP relative-strength chart is moving lower, it tells you that XLY is underperforming XLP. At this time, the S&P 500 is likely going to be feeling some bearish pressure.
You can see in the XLY/XLP relative-strength chart in Fig. 2 just how dramatically sentiment shifted after the S&P 500 reached its low on March 23.
Fig. 2 — XLY/XLP Daily Relative-Strength Chart
The bullish turnaround in sentiment was swift and dramatic.
Perhaps most encouraging is the fact that the bullish trend of the XLY/XLP seems to be accelerating.
Look for the XLY/XLP chart to continue moving higher as we head into the summer.
VIX/VIX3M Relative-Strength Chart
Most traders tend to focus solely on the CBOE Volatility Index (VIX), which measures anticipated volatility being priced into S&P 500 options for the next 30 days, when they think about measuring trader sentiment.
But sometimes focusing only on the next 30 days isn’t a long enough view.
Sometimes it is helpful to expand your horizons out to the next three months, or 90 days. When traders need a longer-term outlook, they can look at the CBOE S&P 500 3-Month Volatility Index (VIX3M), which is a measurement of the anticipated volatility being priced into S&P 500 options for next 90 days.
By comparing the value of the VIX to the value of the VIX3M, you can identify periods when trader sentiment has turned extremely bearish and when it has normalized.
Because these volatility indices measure the magnitude of the price movement traders believe the S&P 500 may make during the measured time frame, the value of the VIX3M is usually higher than the value of the VIX.
After all, if you give the market three months to make a move — like the VIX3M measures — instead of just one month — like the VIX measures — it has a greater chance of making a larger move.
Interestingly, there are times when traders will price in a greater chance of a larger move in the short term than in the long term because they are nervous the market is about to drop. This pushes the value of the VIX up higher than the value of the VIX3M.
The easiest way to compare the value of the VIX to the value of the VIX3M is to create a relative-strength chart of the indices where you divide the value of the VIX by the value of the VIX3M.
Typically, the VIX/VIX3M relative-strength chart will have a value less than one because the value of the VIX is usually less than the value of the VIX3M.
During periods of high market stress, the VIX/VIX3M relative-strength chart will often have a value greater than one because traders are pushing the value of the VIX higher than the value of the VIX3M.
So where is the VIX/VIX3M now?
According to Fig. 3, after soaring to a recent high of 1.3 on Feb. 28, the VIX/VIX3M has once again dropped below one.
Fig. 3 — VIX/VIX3M Daily Relative-Strength Chart
The chart hasn’t dropped as low as it was in late-2019, although it is continuing to trend lower. Regular readers will recall the consistently elevated levels of early March. There was definitely more short-term volatility being priced into the market, but as we noted then, such high volatility is hard to sustain.
The recent readings on the VIX/VIX3M tell us trader sentiment is becoming increasingly bullish. Traders are becoming less worried we may encounter a dramatic bearish pullback in the near term.
The Bottom Line
Looking at the uptrend of the XLY/XLP relative-strength chart in Fig. 2 and the downtrend in the VIX/VIX3M relative-strength chart in Fig. 3, we can see that trader sentiment is decidedly bullish at the moment.
This tells us that if the S&P 500 can close above 3,000, it has a great chance of climbing up to its next resistance level at 3,130 (see Fig. 4).
Fig. 4 — Daily Chart of the S&P 500 (SPX)
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.