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We have blogged about monitoring identifiers that potentially can provide insight into the future direction and stability of the US stock market.  A great place to start is the world of ETF’s. If you don’t know what an ETF is, a brief definition is that they are basically a mutual fund that trades like a stock. When you buy an ETF you are getting a basket of goods or multiple positions in one holding. Most ETFs are designed to track an index and are not actively managed, which means they tend to have lower costs than a mutual fund. Also, as opposed to an Index Fund which trades at the end of the day, ETFs trade in real time during market hours. One analysis we use is monitoring the Consumer Discretionary ETF (XLY) to the Consumer Staple ETF (XLP).  The rationale of tracking these two ETF’s is they provide insight into the mentality of the consumers based on what they are buying.  During cycles of rising unemployment and slowing economic growth, people tend to reduce their discretionary spending, or non-essential spending, while maintaining their spending on staples.  The top five companies in the Discretionary ETF are in order of weighting:

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Consumer Staples represent retailers that provide “must have” items such as food, clothing, tobacco (ironic but true), and healthcare. The list of the top five in Consumer Staples ETF are:

staples

Consumer spending represents 66% of the entire US economy and knowing how consumers are feeling is critical to determining the future of the stock market.  If consumers are confident and feel “wealthy” they will spend more and the opposite is also true. Other indicators we monitor to determine consumer’s temperament include Michigan Consumer Confidence Index, retail sales, inventory, wholesale price changes, and import to export ratios.  We will discuss these other indicators in future blogs but will focus in this blog the correlation of Discretionary vs. Staples as a predictor of the market.

The US economy the past six years experienced two major cycles.  The first cycle is when the government or Federal Reserve initiated multi-trillion-dollar stimulus programs and the second cycle is without stimulus programs, but artificially low interest rates. During periods of monetary stimulus programs, the economy is flooded with low-cost money which prompts stock market rallies. When the stimulus programs ended, the economy slowed, and the stock market crashes. The goal of stimulus programs is to create sustainable economic growth.  Unfortunately, companies used the stimulus dollars to refinance loans to a lower interest rate and buy back their stock and retire it (fewer stocks for sale increases demand and prices).  Although these strategies increase net profits and drive stock prices up, neither approach increases corporate growth.

After the Great Recession had bottomed in March 2010, the stock market began to recover along with the economy. Consumers who were relieved to see improvements started spending on discretionary products and services that include vacations, travel, and dining.  With each trillion dollar Federal Reserve stimulus campaign, which spanned from January 2010 to December 2014, the stimulus sustained the economy, and the stock market rallied.  Note how the Consumer Discretionary ETF (blue line) solidly outperformed the Consumer Staple ETF (orange line) during this period.

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Below is a chart of the S&P 500 index (blue line) with its 50-day moving average (orange line).  Notice the precursor of the stock market selloff in late summer to the declining XLY to XLP in mid-summer of 2011.  Then following the recovery of Consumer Discretionary ETF, the S&P 500 renews its bullish trend.

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However, in December of 2014, the Federal Reserve confirmed investor’s fears and permanently shut off its money-hose of stimulus dollars.  Since then, the economy stopped in its tracks along with the stock market rally.  Since the spring of 2015, S&P 500 corporate net profits and top-line revenue have declined every quarter with this year’s third quarter results not looking any better.  Consumer spending changed, and the Discretionary ETF experiences multiple wild swings in prices with Staples surpassing it several times.

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Not surprising, the S&P 500 ends its multi-year rally in January 2015, and its corresponding chart looks almost exactly like the Consumer Discretionary ETF.

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WHAT DOES THIS MEAN TO ME?

The primary stimuli these past six years to economic growth that resulted in stock market rallies have been Federal Reserve stimulus campaigns.  In every case, the Federal Reserve implemented a new stimulus campaign consumers began spending on discretionary items and the stock market rallied.  Once each stimulus campaign ended, the reverse happened.  Now the Federal Reserve is not entertaining any new stimulus campaigns, and in fact, the committee has expressed its commitment to continually raising the discount rate.  Last December, the Federal Reserved raised the discount rate a scant 0.25% and the Dow Jones Industrial Average (DJIA) had its worst January in its entire history.  After this November’s election, the Federal Reserve has indicated it wants to raise rates again.

Charts can be good predictors of the future activity, but one must be careful.  The stock market is not called the “great humbler” for no reason.  That said, it appears that at best the US stock market remains volatile and at worst experiences a steep selloff.  We recommend a more conservative allocation until the economy begins to grow confirmed by the Discretionary ETF rallying past the Staples ETF.

Be sure to look out for our follow-up piece to this article expressing how we would diversify our assets from a conservative risk, moderately conservative risk, moderate risk, and aggressive risk portfolio!