Friday, May 02, 2008

Thinking in Themes and Seeing in Color: A Key to Trading Success

Themes give the stock market color; they capture the movement of capital from certain sectors of the economy to others. Many traders are color-blind. They fail to detect the themes underlying market moves and, as a result, fail to understand *why* those moves are occurring.

A great example of color blindness came in 2000-2001 when the technology stocks, which had been furious leaders of the rally from the late 1990s to March, 2000, began underperforming large cap Dow stocks. Traders who understood this as a movement toward safety--away from growth and risk and toward stable blue chips--weathered the subsequent bear market far better than those who color-blindly stuck with the NASDAQ all the way down.

Permabears are another great example of color blindness. They see one kind of market, heedless of the themes underneath the movements of the averages.

Note from the chart above that, as the broad market (SPY) has been in decline since mid-2007, the relative strength of consumer discretionary stocks (XLY) to consumer staples stocks (XLP) was also on the decline. This makes sense: in the face of recessionary fears, investors move away from companies dependent upon consumer spending and toward defensive names that will sustain revenues even in a bad economy.

Note, however, that, as SPY made new price lows in March relative to January, the relative strength of XLY to XLP did not follow suit. Now SPY is breaking to multimonth price highs (and is less than 10% off its bull market highs) and the XLY:XLP relationship is moving higher as well. Similarly, we're seeing some recent relative strength of financial stocks (XLF) to materials stocks (XLB), as investors shift money out of commodity-related areas and into beaten-down bank shares.

Make note: It's not just that the stock market is holding its own that is significant; it's that the themes that underpinned the market decline are being unwound. In other words, it's not just the market move that's important; it's also the reasons why the market is moving.

Gradually, but unmistakably, money has been flowing back into high yield bonds. Money has been flowing back into financials. Money has been flowing back into consumer discretionary shares. Money has been flowing into the U.S. dollar. We have been seeing a drying up of risk aversion and a pick up in risk-seeking trades. Slowly, we are seeing a willingness to own financial assets over hard commodities.

That's the color of the current market.


A Shift of Themes Among Sectors

Two Sector Ratios I Watch

Sector Correlations