Let’s Focus On Understanding the Markets Right Now

January 29, 2023  |  Michael Reilly

Is recession around the corner? Will inflation spike as China reopens? Will the Fed stop raising rates in ‘23? We can talk all day about what might happen. 

And sure, it’s reasonable to say that rising interest rates are not conducive to growth assets or that the longer rates remain high the more damage could be done to the economy.

We can talk about mortgage rates doubling or how messed up Washington is these days.

We can talk about a war in Ukraine or Global warming… 

The list goes on and on. 

We can talk about all the bad things that might happen.

Or we can focus on what is actually happening right now.

Because at the end of the day, the only thing that matters is understanding what is actually happening right now.

Not what could happen or what might happen – but what is happening.

So let’s focus on that

Technical analysis is all about using price charts or derivatives of price to visually illustrate market behavior.

So, today I’m going to give you one of the most effective tools I know to gauge overall market risk. 

And the great thing is, you don’t need a degree in Finance to understand it. Anyone can use it.

It’s a simple relative strength ratio comparing the performance of two broad market sectors: Consumer Discretionary stocks and Consumer Staples.

It’s a classic risk-on vs. risk-off comparison. By understanding this relationship, investors gain insight into not only investor behavior but the psychology of consumers.

What we’re really comparing are the things we want (Discretionaries) vs. the things we really need (Staples).

Think about it: If someone is worried about their job, inflation, or a recession, what do most people do?

They tighten your belt – they get lean and mean. They stop buying the extras and focus on just buying the essentials. 

The essentials – those are the staples. The things you need to have regardless of the economy.  It’s toothpaste, food, beverages, etc… essential things you need for your everyday life. These are stocks that tend to do well in an environment where consumers and investors are fearful. 

Conversely, Consumer Discretionary stocks, the things we spend our “discretionary” income on, don’t do well in an environment where investors and consumers are fearful. 

Think about it… are you going to spend your money on an expensive new automobile, TVs, travel, or new clothes if you’re worried about your job? Probably not.

So by tracking the direction of Consumer Staples and Discretionaries and then comparing the performance of each of them to one another, we can get a good idea of the overall health of the market.

We’re analyzing one sector’s performance relative to another.

If Consumer Staples are outperforming Consumer Discretionary stocks, that’s likely happening in an environment where stocks in general are under pressure. 

We’d consider that a risk-off environment and one where investors should consider a more defensive path.

But if Consumer Discretionary stocks are outperforming Consumer Staples, that’s usually happening in an environment where investors and consumers are feeling pretty good about things and are looking to buy more than just the necessities.

We’d define that as a risk-on environment. And an opportunity to add more growthy stocks to your portfolio vs the very defensive ones.

So which is it? Where are we today? Risk-on or Risk-off?

Well, take a look…

Here’s the ratio chart of the Consumer Discretionary Sector vs. the Consumer Staples Sector over the past two years. 

What we can glean from the ratio chart is that Staples relative to Discretionaries peaked in December 2022. Since then, the line chart has reversed lower, illustrating that Discretionaries are favored over the relative safety of Staples.

Because the cap-weighted sector ETF (XLY) is dominated by heavyweights like AMZN and TSLA (which make up nearly 40% of this cap-weighted fund) results can be distorted.

In order to remove that distortion, I’m including an equally weighted ratio chart of Staples and Discretionaries – this helps to eliminate the “Amazon effect.”

The results of the equally weighted analysis of the risk-on vs. risk-off ratio chart is confirming the results of the cap-weighted relative strength ratio chart.

And where there is clear relative strength of one sector over another, we expect to see absolute returns favor the relative strength winner.

As of Friday’s market close, there’s a nearly 17% spread in performance between Discretionaries and Staples. 

Consumer Discretionaries (XLY) has gained 14.50% through the first 27 days of the new year, while Consumer Staples have negative returns -2.27%.

The bottom line is this, in spite of all the scary headlines and the maybes and could-bes, market behavior is inconsistent with global recessionary fears.

We’re just not seeing it. Institutions are buying up growthy areas of the market.

My message to you is this: 2023 is not 2022. 

If you’d like to talk more about Avalon can help you stay adaptable to navigate the markets with success in 2023, schedule a free 1-hour consultation with me or another one of our advisors right now.

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