First up, I'm not predicting anything. I'm not in the business of predictions because it's a fools errand. I trade what happens, and until something happens all of this is academic. However, I am in the business of making money, and that means managing risk. When we see something in the markets that makes our little internal alarm bells start ringing, we should factor that into our decision making going forward.
Secondly, this isn't a unique analysis/comparison. I'm sure there's lots of articles out there covering a similar correlation between these two markets, so I'm not claiming originality.
Alright, let's go! So we're looking at a correlation between:
- The S&P500 , the behemoth of equity markets and benchmark of US economic healthy/activity (orange on the main chart).
- XLY:XLP - a custom symbol that looks at the relationship between the Consumer Discretionary Sector ( XLY ), and the Consumer Staples Sector ( XLP ). In a nutshell, if this symbol (black on the charts) is moving up, consumers are spending more on discretionary items, and vice versa if it's moving down. The theory is that if consumers are spending on discretionary (read: luxury) items, they are feeling good about their situation and the situation of the economy going forward. The opposite is true if they aren't.
Why is this comparison interesting? Basically, these two symbols/markets should move in sync, and do have a strong historic correlation. A rising S&P500 is a sign of economic strength, which means XLY:XLP should be rising along with it. The REALLY interesting things happen when that correlation goes away.
Okay, we're going to commence with a review of previous correlation divergences, and a look at what happened to each symbol. By the end of our review you should have an idea of where I'm going with this, but I'll cover it at the end as well. I've created a second chart that is numbered so you can follow which market cycle/time period I'm talking about:
- 1. 2007-2009 GFC: Okay, let's start with the biggie. I won't go into the history or the fundamentals behind the GFC , so let's look at our charts. It's important to begin by noting that this was the longest correlation divergence of the last few decades - I'll leave you to decide whether that's significant or not.
What we can see on our chart is XLY:XLP peaking in late 2004, and forming a series of lower highs until the bottom of the markets fell out in 2007-2008. Contrast that with what happened to the S&P500 in the same period; a slow, steady rise, culminating in a peak in October 2007. What really jumps out at me from studying that period is how a week or two after the S&P500 peaked (was anyone calling it that back then?) the XLY:XLP symbol made multi-year lows (since 2003). Basically, if we take our theory that a rising XLY:XLP is a sign of economic strength, then something was seriously wrong with the US economy from 2004-2007. Of course, we now know that there was.
Lastly, because it'll become important later on... the on the main chart (it's based on the S&P500 ) shows a distinctive pattern seen prior to all market corrections over the last two decades. A series of lower highs; indicative of failing momentum in the market.
- 2. Market Bottom - 2009: The S&P500 bottomed out in early 2009 after falling 50% in 1.5 years. What we can see from our comparison is another correlation divergence, but a one this time. XLY:XLP formed higher lows, and combined with a S&P500 momentum divergence of the same nature, it was a clear signal that markets had started reversing. I encourage you to check out that period in more detail; in particular, have a look at how XLY:XLP started rising sharply a few weeks before the S&P500 followed suit. It's no secret that the Consumer Discretionary Sector is a market leader in expansions, and that was a perfect sign of how you can use it to time markets - which some people say is impossible!
- 3. 2011 Downturn: Markets rose steadily for two years until early 2011, when the S&P formed the first of what would be three (roughly) equal peaks. Looking back at XLY:XLP, we can see that it actually topped out at that first peak in February 2011. From there it fell steadily, while the S&P500 sorted itself out and was ready to fall (read: smart money). Markets fell roughly 15-20% before recovering in late 2011.
- 4. Minor drop? This one is pretty interesting (well, I find it interesting). We can see another correlation divergence in 2014, when the XLY:XLP symbol formed lower highs, while the S&P500 kept rising. What I find interesting is the fact that this didn't lead to any sustained drop ... However, if you look at the S&P500 in September 2014, you can see it actually fell quite heavily, and sharply, but recovered quickly. In fact, at it's peak it fell 10% in a month - it was the largest fall since 2011.
- 2014-2016 - Crazy town: Okay, let's get to one of the stranger periods in the S&P500 over the last few decades. Jumping back to our charts we can see that the S&P500 topped out in (roughly) mid 2015. However, XLY:XLP actually formed higher highs from March 2014 to November 2015. That latter peak was actually formed on a lower high on the S&P500 - clearly, something was askew. Sure enough, markets went haywire, and had two sharp corrections in what was effectively a sideways movement for the entirety of June 2015 - July 2016. One interpretation is the consumers were blindsided by the falls, and it was linked to other factors (do some research, it'll be interesting!). Note: Look at that distinctive momentum pattern on the S&P500 ...
- 6. Recovery within a recovery: The S&P500 reached it's 2015 high in July of 2016, but we can see that XLY:XLP symbol was far more sluggish in that period. Fun fact: it wouldn't reach its 2015 high until late in 2017. However, the really interesting thing is that the true S&P500 market expansion didn't occur until the XLY:XLP symbol had its largest single week rise in years during the last week of October 2016. We even see a small correction in the S&P500 in the weeks prior to that. Once consumer discretionary spending recovered and surged, so did the S&P500 for the next 3-4 years (until now!).
- 7. Today - what's going on? We now reach more recent history. As we all know, the S&P500 has surged higher over the last few years, breaking records along the way. We had a mini crash in late 2018, which was quickly recovered, and today the index sits at all-time highs. Great? Well, yes... and no.
My concern (and remember this isn't a prediction - it's an observation on potential risk factors), is two-fold: firstly, XLY:XLP has seriously diverged from the S&P500 , and peaked in June of 2018. Since then it's fallen into a distinctive of lower highs, and shows no signs of recovering. Consumers aren't happy or confident for some reason (rising interest rates, trade-war , and Trump are some of my initial thoughts). Combine that with what is by now, I hope, a fairly distinctive and obvious momentum pattern on the S&P500 . Momentum has been falling for over a year now (since January 2018), and scarily mirrors previous significant market corrections/downturns...
Alright. So let's recap... We've had a look at some interesting patterns and correlations that can be found when you create a XLY:XLP symbol, and compare it to the S&P500 Index. We've examined previous market corrections, and hopefully drawn some interesting lessons that we can POTENTIALLY (I can't stress that enough) use going forward.
So, what am I saying about the health of the S&P500? Well, nothing really. The market is still rising, and until it's not, that's the only factor that is relevant. Betting against a rising market (especially an intrinsically upward biased one such as the S&P500 ), is a recipe for disaster. What I am saying is that everything doesn't seem as rosy as the S&P500 would have us think. Consumers are hurting and/or worried, and that's not good for the health of the US economy. Whether that will result in any downward correction is anyone's guess.
I'll sign off by saying that I remain long in equity markets. I've seen no sign of a proper correction underway, and in fact I won't until the day that markets fall heavily. I am, however, tightening by stop losses and adjusting my risk management procedures to potentially account for increased market and movements.
Okay, that's all for today. It's already an essay. I hope you've learnt something, and found this moderately interesting! Let me know if you have any queries/comments/suggestions.
All the best,
So we'll see what happens over the coming weeks and months :) it's just one part of the risk model I've developed.