Risk Off Gauge That Correctly Signaled 2000 and 2007 Top is In Freefall, But …

Twice in 2014 we looked at the XLY:XLP risk on/risk off ratio for clues about the market’s next move. Twice the XLY:XLP ratio pointed us in the right direction. Now it’s pointing lower, which contradicts an even more powerful indicator.

The ratio of two diametrically opposed asset classes often provides insightful clues about what investors are doing.

The XLY:XLP ratio is one such example.

Unlike many hypothetical indicators, the XLY:XLP ratio is an actual money flow indicator, based on what investors are doing, not saying or thinking.

XLY represents the Consumer Discretionary Select Sector SPDR ETF. XLP represents the Consumer Staples Select Sector SPDR ETF.

The XLY:XLP has offered some excellent signals and tell tale signs both long-term and short-term.

Long-term:

A breakdown of the XLY:XLP ratio correctly signaled the 2000 and 2007 market tops.

Short-term:

We looked at the XLY:XLP ratio twice this year.

The first time was on May 20, when it was at the verge of breaking down.

The conclusion back then was that there were simply to many bears to drive the S&P 500 down.

The second time was on August 7, when the XLY:XLP ratio rose despite an S&P 500 selloff (see chart below for dates).

The conclusion was that the XLY:XLP ratio rally actually reduced the risk of an immediate stock market decline. The S&P 500 rose steadily for the next 90 days or so.

This time around the picture looks different, as the ratio has broken below long-term trend line support. This suggests that the time of shallow, V-shaped corrections – so prevalent throughout 2013 and 2014 – is over.

Another 2000 or 2007-like Top?

Does this breakdown also foreshadow another bear market, like it did in 2000 and 2007.

Context may be key here. The 2000 and 2007 market tops were also preceded by an even more important sell signal (more about this signal in a moment). This signal hasn’t triggered yet convincingly.

Furthermore, a close-up look at the XLY:XLP ratio since 2008 shows two prior trend line breaks (2012 and 2013, red circles) that turn out to be false signals. Unlike the 2001 – 2007 move, the post 2009 rally has been quite choppy, testing and breaking support more frequently.

The XLY:XLP ratio by itself is telling us that there is potential for further losses, but as the 2012 and 2013 breakdown reversals show, any correction may hit rock bottom without notice.

Looking at the ‘Big Guns”

As mentioned above, another indicator that not only foreshadowed the 2000 and 2007 market tops, but also predicted that every correction since 2009 would lead to new highs, has not yet given a convincing sell signal.

The indicator is probably the most valuable gauge for any investor at this moment.

It is discussed in detail here: 3 Strike Wall Street Law – QE Bull Market Only One Strike away From Knock Out

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

S&P 500 Selloff Ironically Reduced Risk of Market Crash

This is a truly counter intuitive development: The recent sell-off, which knocked the S&P 500 from 1,991 to 1,911, actually decreased the risk of a market crash a la 2000 or 2007. Here’s why:

On May 20, we looked at an indicator that has the distinct reputation of signaling the 2000 and 2007 meltdowns (“A Look at the Risk Off Gauge That Correctly Signaled the 2000 and 2007 Tops“) .

Since then, this indicator has delivered a surprising twist.

We are talking about the XLY:XLP ratio.

XLY represents the Consumer Discretionary Select Sector SPDR ETF. XLP represent the Consumer Staples Select Sector SPDR ETF.

Consumer discretionary is an economically sensitive, high-octane sector. Consumer staples is an economically defensive sector.

The XLY:XLP ratio reflects how much risk investors are willing to take.

The chart below plots the S&P 500 against the XLY:XLP ratio.

In late February, XLP started to outperform XLY (‘risk off’ mentality’). This led to a falling ratio. By May, the XLY:XLP ratio was on the verge of breaking below the trend line support.

Such a breach of trend line support foreshadowed the 2000 and 2007 rallies.

But then something curious happened. XLY recovered and so did the ratio.

Defensive sectors tend to fair better during poor markets, but despite the most recent selloff, which knocked the S&P 500 (NYSEArca: SPY) from 1,990 to 1,910, investors actually preferred XLY over XLP.

Why? I don’t know.

At the end of the day, a ‘market crash’ signal (like in 2000 and 2007) was averted.

The XLY:XLP ratio is just one of many indicators used to analyze the market and assess the (much talked about) risk of a market crash.

The Profit Radar Report just published an article on the most accurate ‘market crash vs correction’ indicator. This indicator correctly anticipated the 1987, 2000 and 2007 crash. At the same time, it exposed the 2010, 2011 and 2012 corrections as temporary blips.

More information is available here: How to Discern a Major Market Top

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Will The ‘Risk on’ Trade Live on?

The market has been alternating between ‘risk on’ and ‘risk off,’ with a heavy emphasis on risk on. A look at stocks shows that risk on is still alive and well, but here’s one fact that hasn’t confirmed the most recent spout of risk on.

‘Risk on’ in one of those fashion terms linked with the QE bull market and expresses investors’ comfort level with high-risk assets.

Will risk on continue to live on?

Risk on received another shot in the arm by Shinzo Abe (Japan’s Prime Minister) and his easy money policy.

How exactly does Abenomics affect the domestic stock market?

Big Boy’s Printing Machine

The yen carry trade is like an ATM for the big boys of investing. A normal carry trade would see big institutions borrow money in countries with low interest rates and invest the money in fixed income vehicles of countries with high interest rates.

For example, if the yen had zero interest rates and U.S. bonds yielded 5%, a firm would want to borrow yen and buy U.S. bonds for a nice spread (positive carry). The biggest risk is a rising yen.

The modern yen carry trade is slightly different. Both the U.S. and Japan are pursuing a 0% interest rate policy. Institutions now borrow the yen and buy U.S. stocks.

The chart below plots the S&P 500 against the Japanese yen. The yen could also be represented by the CurrencyShares Japanese Yen Trust ETF (NYSEArca: FXY).

The widening margin between the S&P 500 and yen is the ideal carry trade scenario. The wider the gap, the bigger the yen carry profits (a falling yen makes the yen loan cheaper).

The second chart plots the S&P 500 (NYSEArca: SPY) against the USD/JPY currency pair.

The USD/JPY currency pair measures the value of the dollar and yen in relation to each other and reflects how many yen are needed to purchase one U.S. dollar.

Up until early February the correlation has been tit for tat. But the USD/JPY pair did not confirm the S&P’s recent rally. Why?

A closer look at USD/JPY provides interesting insight:

The USD/JPY pair is struggling to overcome resistance around 103.70, which is made up of the May 2013 high, ascending red trend line resistance and 61.8% Fibonacci retracement (going back to January 2 high).

While this confluence of resistance is the perfect spot for the USD/JPY rally to stop, it’s too early to say if it is enough to stall the risk on track.

103.70 is the dividing line for the risk on yen carry trade.

As long as USD/JPY stays below 103.70, carry trade and U.S. investors may have to deal with a risk off environment for a bit.

Those who have a hard time believing that there’s a rhyme and reason for the ebb and flow in the investing universe may enjoy the following article.

Although the S&P 500 has surpassed its previous all-time high (unlike USD/JPY), the S&P 500 is at a similar inflection point.  What does it mean? Details here:

Is it Too Late to Jump into Stocks? Watch S&P Reaction to This Inflection Point

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.