Stocks
XLY

How to Confirm Bullish Sentiment With Relative-Strength Charts

These certainly are exciting times on Wall Street.

InvestorPlace Roundup: The Hottest Stocks of the Day

The S&P 500 hit another all-time, intra-day high on Tuesday, and it looks like it might be gearing up to do it again either today or sometime later this week.

Perhaps the best part about this latest bullish run is how bought-in everyone on Wall Street seems to be.

Sometimes the major stock indexes — like the S&P 500 or the Dow Jones Industrial Average — can be pushed higher by the strong performance of just a few stocks. That doesn’t seem to be the case this time though.

This move seems to be powered by a broad bullish consensus building among traders.

How do we know?

Two of our favorite relative-strength charts are telling us so.

XLY/XLP Relative-Strength Chart

One of our favorite indicators to gauge whether we are in an expansion phase or a contraction phase is the comparison of the two consumer-based stock sectors: consumer discretionary and consumer staples.

Consumer discretionary stocks represent companies like Amazon (NASDAQ:), Home Depot (NYSE:) and McDonald’s (NYSE:), which tend to do better when consumers have extra money to spend and enough confidence in their economic future to spend it.

Consumer staples stocks represent companies like Procter & Gamble (NSYE:), Coca-Cola (NYSE:) and Walmart (NYSE:), which tend to do well even during economic downturns because people tend to continue buying shampoo, Coke and general supplies when the economy stinks.

You can see in the chart above which stock sectors tend to outperform during various stages of the business cycle. Consumer discretionary and consumer staples are at opposite ends of the cycle.

Sector Rotation During the Business Cycle

Consumer discretionary stocks typically start to outperform near the bottom of the business cycle. This is when the economy is shifting from its contraction to its expansion phase. Consumer staples stocks typically start to outperform near the top of the business cycle. At the top of the cycle is when the economy is shifting from its expansion phase to its contraction phase.

By comparing these two stock sectors, we can see whether Wall Street is preparing for continued expansion or continued contraction.

When consumer discretionary stocks are taking the lead, we can be increasingly confident that traders believe both the economy and the stock market are doing well. When consumer staples stocks are taking the lead, we can be increasingly confident that traders believe both the economy and the stock market are doing poorly.

You can easily compare the performance of these two sectors by creating a relative-strength chart of the Consumer Discretionary Select Sector SPDR Fund (NYSEARCA:) and the Consumer Staples Select Sector SPDR Fund (NYSEARCA:), where XLY is the first exchange-traded fund in the pairing and XLP is the second (XLY/XLP).

When the XLY/XLP relative-strength chart is moving higher, it tells you that XLY is outperforming XLP, and the S&P 500 is likely doing well. Conversely, when the XLY/XLP relative-strength chart is moving lower, it tells you that XLY is underperforming XLP, and the S&P 500 is likely feeling some bearish pressure.

The comparison of the XLY/XLP relative-strength chart and the S&P 500 Index (SPX) chart in the figure below shows that the S&P 500 chart typically moves lower with the XLY/XLP chart.

XLY/XLP Compared to the S&P 500 (SPX)

Source: TradingView

The S&P 500 doesn’t always move in lockstep with the XLY/XLP chart, but seeing the XLY/XLP start to move lower can be a good indication that the S&P 500 might start moving lower.

Right now, the XLY/XLP chart is finally starting to form some higher lows (see the green arrow). This tells us that trader sentiment is becoming more bullish.

Look for the XLY/XLP chart to start forming higher highs in the next few months to go along with its higher lows.

VIX Relative-Strength Chart

Most traders tend to focus on the CBOE Volatility Index (VIX) when they think about measuring trader sentiment. The VIX is a measurement of the anticipated volatility being priced into S&P 500 options for the next 30 days.

However, sometimes focusing only on the next 30 days isn’t a long enough view. Sometimes it is helpful to expand your horizons out to the next three months, or 90 days. When traders need a longer-term outlook, they can look at the CBOE S&P 500 3-Month Volatility Index (VIX3M), which is a measurement of the anticipated volatility being priced into S&P 500 options for a three-month time frame.

By comparing the value of the VIX to the value of the VIX3M, you can identify periods when trader sentiment has turned extremely bearish and when it has normalized.

The value of the VIX3M is usually higher than the value of the VIX. That’s because it measures the magnitude of the price movement traders believe the S&P 500 may make for a longer time period. After all, if you give the market three months to make a move, it has a greater chance of making a larger move.

Interestingly, there are times when traders will price in a greater chance of a larger move in the short term. Usually, this happens because they are nervous the market is about to drop, and that fear pushes the value of the VIX up higher than the value of the VIX3M.

VIX/VIX3M Compared to the S&P 500 (SPX)

Source: TradingView

The easiest way to compare the value of the VIX to the value of the VIX3M is to create a relative-strength chart. Start by dividing the value of the VIX by the value of the VIX3M.

Typically, the VIX/VIX3M relative-strength chart will have a value less than 1, because the value of the VIX is usually less than the value of the VIX3M.

During periods of high market stress, the VIX/VIX3M relative- strength chart will often have a value greater than 1. That’s because traders are pushing the value of the VIX higher than the value of the VIX3M.

So, where is the VIX/VIX3M now?

According to the figure above, the VIX/VIX3M is at its lowest level since October 2018. As you can see in the comparison of the VIX/VIX3M relative-strength chart and the S&P 500 (SPX) chart, the VIX/VIX3M typically moves higher when the S&P 500 moves lower and vice versa.

So, the fact that the VIX/VIX3M is at a 52-week low tells us trader sentiment is extremely bullish.

The Bottom Line

At the moment, the only thing that looks like it could potentially derail the bullish market sentiment we are experiencing on Wall Street right now is a collapse of the trade talks between the United States and China.

Traders appear quite comfortable with everything else that is happening — the impeachment proceedings, earnings, interest rates and so on.

John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: . If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.

The post appeared first on InvestorPlace.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

In This Story

XLY XLP AMZN HD WMT

Latest Stocks Videos