Economic Indication for Future Market Direction

There are a lot of “experts” attempting to predict the future market direction and advising you on what to do with your 401k and other retirement money.  One of the biggest problems with the conventional wisdom is that financial advisors love to tell you when to get into the markets but fail to tell you when to exit.  They often profit from your money staying fully invested in mutual funds and annuities and would rather have you suffer and stress during market turndowns rather than helping you protect your money and increase returns with market timing.

There are simple techniques, such as spread ratio, that you can use to help you identify major shifts in the market sentiment.  While this won’t offer you exact timing on when to buy or when to sell, it can make you aware of when to start looking into safe haven investments and when to look for aggressive gain securities. You can then apply Online Trading Academy’s Core Strategy to enter and exit the markets properly.

Traders and investors will often anticipate the potential direction of the economy and adjust their positions accordingly. If you monitor the performance of the sectors they are putting money into, you can start to see which is leading. Certain sectors outperform the others when the markets are bullish and others will outperform in bearish markets.

The sectors that usually represent the bullish and bearish extremes of the equity markets are the Consumer Discretionary and Consumer Staples.  According to Investopedia, the Consumer Discretionary Sector is, “A sector of the economy that consists of businesses that sell nonessential goods and services. Companies in this sector include retailers, media companies, consumer services companies, consumer durables and apparel companies, and automobiles and components companies.” They define Consumer Staples as, “The industries that manufacture and sell food/beverages, tobacco, prescription drugs and household products.”

When markets are poised for a strong rise, investors and traders would buy the discretionary companies and that sector would outperform the staples.  During times of economic bust, one would expect the discretionary companies to underperform staples as investors would not buy companies facing slow or no growth.

We saw this exhibited during the 2008 financial crisis. While both sectors dropped, the staples did maintain more value while the discretionary dove.

When the markets turned bullish in 2009, the opposite occurred.

As a chartist, there is a way to use this relationship and fine tune turning points in the market. TradeStation has a useful technical indicator called the Spread Ratio. This tool allows the trader to see a visual representation of the price of one security divided by another. By using trend lines, a trader can observe changes in the performance of two securities and make decisions about the broad markets.

To see changes in the overall market, I use a spread ratio that divides the closing price of the XLY, the consumer discretionary ETF, by the closing price of the XLP, the consumer staples ETF. If the ratio line is rising, the discretionary are outperforming the staples and we are in a bullish trend. Should the trend break and the ratio line decline, we are experiencing a bearish move and trend in the markets. Support and resistance work the same on the ratio as they would on a stock.

Notice the monthly charts of the XLY and XLP with the spread ratio. The breaks in trend correctly identified the shifts from bullish to bearish markets. Although this technique will not give you exact tops and bottoms, it will alert you to major changes in the markets.

The larger timeframes on charts show us the major trends, and we can adjust our biases accordingly. However, as traders we often want to look at shorter timeframes to see smaller tradable trends. This ratio analysis will also help with that. Simply adjust the chart’s timeframe to your needs but keep in mind that the larger timeframe trends always dominate over the shorter.

By looking at the rotation between staples and discretionary using the spread ratio, traders can gain additional insight as to the future direction of the markets. Until next time, trade safe and trade well!

Learn to Trade Now