For Clues to Market Direction, Watch My Favorite Ro-Ro Indicator

At this time of year folks should be thinking about weekend getaways at the beach … or some other mid-summer relaxation with friends and family.

But for investors, this summer has been another white-knuckle ride of market volatility …

For the third straight August, investors are facing widespread uncertainty: The approaching fiscal cliff … a global economic slump … upcoming U.S. elections. And of course, Europe’s never-ending debt crisis is still front page news just as it was this time last year … and in the summer of 2010 as well.

Adding fuel to the fire is a persistent drum-beat of headline risks about how the European Union can possibly solve its debt woes.

The predictable result has been another summer of volatile markets, with the Dow Jones Industrials on a roller-coaster ride — diving more than 800 points in the month of May alone, followed by a whipsaw 700-point-plus rebound since June’s low.

It’s been a Yo-Yo market — or more accurately a Ro-Ro market — as the pendulum swings relentlessly from risk-on to risk-off mode and then back again.

So it’s really no surprise why investor sentiment appears so depressed at the moment as a result of this market turbulence and uncertainty. And there are still plenty of lingering concerns that could send jittery markets into another tailspin.

To help provide clues about the stock market’s next potentially major move, I’m going to introduce you to …

One of My Favorite Risk-on/Risk-off
Market Indicators

It’s a custom index I track that’s a good gauge of whether positive or negative sentiment has the upper hand in the stock market.

I simply take the values for the Standard & Poor’s Consumer Discretionary stock index and divide by the S&P Consumer Staples stock index (see chart below).

It’s a handy comparison that shows how well consumer discretionary stocks like Amazon — that are more cyclical and dependent on consumer spending — are performing compared to staples like say, Proctor and Gamble, which tend to be steady market performers regardless of the economic outlook.

At a glance you can see that consumer discretionary companies had the upper hand in terms of market performance from September 2011 through this past April — when the S&P 500 Index gained 19.3 percent overall.

This was clearly a risk-on period in markets, when aggressive stocks and commodity investments outperformed more conservative strategies.

But earlier this year stock market leadership traded places, with consumer staples outperforming discretionary companies by a wide margin since April. Over this period, the S&P 500 has been a lot more volatile, posting a total return of just 1.9 percent.

The current direction of this indicator tells me that over the past several months, risk-off mode has been the dominant trade of the day.

Overall, the S&P 500 Index is up more than 11 percent year-to-date, a surprisingly good performance given the volatility we’ve witnessed. Still, it’s clear that many investors remain unconvinced, as stocks climb the proverbial wall-of-worry.

In fact, individual investors have pulled $71 billion out of U.S. stock mutual funds so far in 2011, even as the market has moved quietly higher! Considering this one-sided negative sentiment, it’s quite possible that a fair amount of bad news has already been priced into the markets at this point, a potential positive.

On the other hand, those who do remain invested are acting very cautiously with their stock selection at present: Favoring defensive sectors like telecom, health care, and yes, consumer staples.

This Raises a Red-Flag
on the Markets in My Mind …

If the bullish move in domestic stocks since June is to continue, I would expect the rally to broaden out to more economically sensitive, cyclical stocks and sectors such as technology, industrials, and of course, consumer discretionary companies.

In other words, I’m looking for renewed leadership by the sectors that stand to benefit most from a stronger economy and profit growth down the road.

In fact, stronger performance from these names could be one of the best indications that perhaps the worst is indeed behind us and the rally has more room to run. But if these cyclical sectors fail to participate more fully, that would be a signal of more potential trouble ahead.

Since my focus is investing in exchange traded funds, two of the ETFs I’m keeping a close eye on right now include the SPDR Select Sector Consumer Discretionary (XLY), and the SPDR Select Sector Consumer Staples (XLP).

I’m watching these two ETFs for clues as to whether the current risk-off climate will continue, or reverse back to favor risk-on trades again.

XLY in particular has been one of the strongest performing domestic ETFs so far this year, up 12 percent. But lately it has been struggling to keep up the pace as shown in the chart below.

XLY has been locked in a sideways trading range since June, even while other more defensive ETFs have outperformed it. This tells me investors are still clinging to a risk-off mentality, and aren’t as enthusiastic about stocks that would benefit from a pickup in the economy.

But if XLY can break out above its recent highs, and resume its leadership role, this could signal a return of the risk-on trade in markets, which could help sustain this rally. Stay tuned!

Best wishes,

Mike

Mike Burnick, with 30 years of professional investment experience, is the Executive Director for The Edelson Institute, where he is the editor of Real Wealth Report, Gold Mining Millionaire, and E-Wave Trader. Mike has been a Registered Investment Adviser and portfolio manager responsible for the day-to-day operations of a mutual fund. He also served as Director of Research for Weiss Capital Management, where he assisted with trading and asset-allocation responsibilities for a $5 million ETF portfolio.