I've been following the stock market for a long time and I'm always searching for that perfect signal that never fails. I still haven't found it and there are never any guarantees in the stock market, BUT following the rotation of money to aggressive areas of the stock market can provide fairly reliable confirmation that a bull market rally is sustainable. The four relative ratios that I rely on the most are the following:
1. Consumer discretionary vs. consumer staples (XLY:XLP)
This is just a very simple analysis of whether market participants are more interested in owning the more aggressive discretionary stocks or the more conservative staples stocks. If our economy looks to improve, discretionary stocks should perform better. Since the stock market tends to look ahead 6-9 months, it just makes sense that this XLY:XLP ratio should move higher to support equities.
2. Transportation stocks vs. utility stocks ($TRAN:$UTIL)
An improving economy requires more shipment of goods and also encourages more travel, which benefit transportation companies. An improving economy also typically puts pressure on the Fed to raise interest rates. Those rising treasury yields offer competition to the strong dividend yields of utilities. Therefore, as the market looks forward and sees economic improvement, it's not at all unusual to see the $TRAN:$UTIL rising to accompany strength in the benchmark S&P 500.
3. Russell 2000 vs. S&P 500 ($RUT:$SPX)
The Russell 2000 is made up of small cap stocks, which tend to be much more volatile and much more rewarding during an up cycle in equities. Also, $RUT stocks do nearly all of their business domestically and, therefore, are much more reactive to economic conditions here in the U.S. Many S&P 500 companies are multinational companies that rely on global economic conditions. An uptrend in the $RUT:$SPX results from a strengthening U.S. economy relative to the world and also benefits from investors' increased appetite for risk.
4. Banks vs. REITs ($DJUSBK:$DJR)
In order for our economy to run full speed ahead, we need availability of credit. The U.S. economy relies on it. When economic conditions deteriorate, banks become much more selective with respect to lending. As loan losses mount and interest rates fall (to combat economic weakness), bank profits tumble and their lending practices slow. Therefore, I like to see strength in banks to help support a stock market rally. I don't need to see banks outperform the S&P 500, I simply want to see them go along for the ride. REITs are much like utilities in that they tend to pay high dividends and are a more conservative area of the market. A rising $DJUSBK:$DJR provides a better backdrop for a sustainable stock market advance.
Those are four key ratios that I like to follow. When one or more of these ratios drop during a stock market rally, the more concerned I become about "under the surface" signals. Let's take a look at where we currently stand on the benchmark S&P 500 and these four key ratios:
This rally is on very solid footing right now, in my opinion. That means I'm going to remain quite aggressive in my trading, continuing to look to trade companies that beat Wall Street consensus estimates for revenues and EPS. John Hopkins of EarningsBeats.com and I will be conducting a joint webinar on Monday at 4:30pm EST to discuss the market, trading strategies and risk management. I will focus on helping you establish an organized ChartList to help identify solid reward to risk trading candidates.
The webinar is being hosted by EarningsBeats.com and you can CLICK HERE for more information on registration and cost.
Happy trading!
Tom
