To be fair, XLY has not been an awful trade. The largest discretionary ETF hit a new all-time higher earlier Thursday and has returned almost 2.2% over the past 90 days. However, that 2.2% gain lags the S&P 500 by 80 basis points while XLP has been three and a half times better over the same period. Additionally, XLY is in the midst of its seasonally favorable period.
Still, the XLY/XLP ratio and its penchant for forecasting previous market declines should be monitored closely by investors.
Chart Courtesy: AGD Capital Management
“As you can see, the ratio did a pretty good job of foreshadowing major market moves. As the market continues to rally off its 2009 bottom, the ratio had also been making higher-highs, pretty much in tandem. It’s recently where we are starting to see a divergence where the market grinds higher and the ratio fails to make higher highs. The same divergence was occurring before the market collapsed in 2008,” said Psarofagis. “Although in isolation, this indicator doesn’t necessarily constitute a “sell signal”, but has been a fairly good early warning of risk aversion and analyzing the sustainability of the market’s advance.”