Wednesday, August 20, 2008

Looking at Relative Strength as a Sentiment Gauge

My last post explained how the sentiment of investors and traders regarding the economy is reflected in the relative performance of various classes of bonds. Here we're looking at the relative performance of stock market sectors as a barometer of sentiment. The relative strength of consumer discretionary shares (XLY) reflects investor confidence in economic strength. Conversely, when there is worry that housing-related concerns and rising prices weigh on consumer spending patterns, investors and traders express this outlook by selling consumer discretionary stocks.

We can see from the chart above that, after a year of steady underperformance relative to the S&P 500 Index (SPY), the consumer discretionary stocks have gone into a relative strength range for 2008. After having recently visited the top of that range, we're now seeing a pullback. This pullback in relative strength for XLY corresponds to a period of economic concern, as also seen in rising Treasury prices (flight to quality) and continued negative news regarding housing.

I will be watching this relationship closely for indications of shifting economic sentiment among traders/investors.