Those who have tracked my work over the last decade know I’m a huge fan of intermarket analysis and using relative price movement to analyze what’s really happening beneath the market’s surface. Why does this type of analysis matter? Because it’s the only way to cancel out beta. It’s also the only way to see what the market is truly thinking about certain sectors.
Broadly speaking, there are two broad categories of sectors. Those that are more cyclical and that investors position into when in an offensive stance, and those that are defensive that investors flock to when afraid of the near term. Cyclical sectors of the stock market tend to have thin dividends, if they pay out at all. Defensive sectors of the stock market tend to have consistent and healthy dividends.
From a stock market perspective, there are only three consistent and reliable defensive sectors. Those are utilities, consumer staples, and healthcare. These sectors carry a lower volatility profile relative to broad market averages, have dividends, and tend to be in parts of the economy which are focused on things each of us “need.” Whether we are in a boom time, a recession, or a Great Depression, all of us need electricity, food, and medicine to survive.
I often reference utilities because it’s the most bond-like sector of the stock market. It can indicate stress is coming to financial markets. But it isn’t the only defensive sector worth paying attention to.
If we agree that consumer staples are defensive, then we can get some interesting signaling in their movement not just relative to the broader stock market, but also relative to other consumer cyclical parts of the marketplace. Below is the price ratio of the Consumer Staples Select Sector SPDR ETF (NYSEARCA:XLP) relative to the Consumer Discretionary Select Sector SPDR ETF (NYSEARCA:XLY).
Think of this like a need versus want relationship. If the ratio is rising, it suggests the market is favoring needs and not favoring wants.
What do you see here?
There’s been a pretty sizeable outperformance burst in the last several weeks. Why would this be happening with Federal Reserve Chair Jerome Powell saying the economy is strong? Probably because at investors are worried about consumer spending on discretionary items on a go-forward basis.
The Bottom Line on Consumer Staples Stocks
The point here is simple. For consumer staples stocks to be outperforming consumer discretionary stocks, there must be smart money at the margin worrying about the state of the consumer.
Should this relative strength in consumer staples continue, it would suggest we are in a highly dangerous risk-off environment right now. From there, defensive stocks would continue to lead and broader markets would continue to tumble.
Watch what you need here. It’s not what you want to see. But it can help with getting defensive in what is likely going to be a very difficult next several weeks.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
