ETF Ratios Sending Mixed Signals

Should you buy stocks or not?

Exchange-traded funds (ETFs) are a wonderful invention. Sure, they provide low-cost, tax-efficient alternatives to other types of collective investments but they are also easily observable indicators of market sentiment.

If you look at a chart tracking the price ratio of the Consumer Discretionary Select Sector SPDR ETF (NYSE Arca: XLY)  and the Consumer Staples Select Sector SPDR ETF (NYSE Arca: XLP), you might think we’re headed into an economic version of the Era of Good Feelings.

Why? Because XLY (discretionary) stocks are pulling ahead of the XLP (staples) issues. XLY is populated by companies that produce stuff you want to buy; XLP is made up of companies making goods you have to purchase. The big holdings in the XLY portfolio include Amazon.com, Inc. (Nasdaq: AMZN), Walt Disney Co. (NYSE: DIS) and Home Depot, Inc. (NYSE: HD). XLP’s weighted by the likes of Proctor & Gamble (NYSE: PG), CVS Health Corp. (NYSE: CVS) and Costco Wholesale (Nasdaq: COST).

The rise in the ratio is evidence of consumers’ willingness to spend more of their money on non-essentials. After all, you gotta be confident about your financial resources before laying out your hard-earned bucks for a Star Wars flick.

Click to Enlarge

To the extent the XLY/XLP chart is encouraging, the HYG/LQD graph is troubling. HYG is the iShares iBoxx $ High Yield Corporate Bond ETF, a proxy for junk bonds. The iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSE Arca: LQD) represents higher-quality corporate debt. Divide the price of HYG by LQD’s cost and you get a different angle on economic buoyancy. The higher the HYG/LQD ratio, the more willing are investors to undertake risk. As you can see from the chart below, the ratio moved fairly well in lockstep with the stock market — represented by the SPDR S&P 500 ETF (NYSE Arca: SPY) – through late 2013. Then, the ratio began to narrow as stocks continued northward.