If one is useful, two is better.
That’s the theory when it comes to tracking the ratio of one market with another. To be fair, there are a sea of possibilities and much of it is noise. But there’s a bit signal tucked away in there too, offering some guidance on broad market trends.
Here are some examples, based on several pairings of ETFs. The goal here is to identify trends, and perhaps turning points, that aren’t as clear when looking at one market in isolation. Alas, even under the best of circumstances there’s a fair amount of subjectivity to wade through. Mr. Market and his minions are a cagey lot and so there’s always room for interpretation and debate. That said, you can pick up some useful signals in this corner… sometimes.
With that mind, let’s go exploring and see what we can find in several market relationships as of today’s close (Wed., March 16).
US stocks (SPY)/bonds (BND): The trend for this ratio is usually up, as expected. Stocks beat bonds over the long haul. But markets never move in a straight line and so it helps to periodically step back and assess the big picture on a relatie basis. To wit, the basic risk-on/risk-off trade-off for equities vs. fixed income. This dance card may be changing if we’re in an extended run of rising interest rates. Leaving that topic aside for now, the SPY:BND ratio tells us quite a bit about where we’ve been in recent years and how we got there. In the chart below, when the line is rising, that’s an indication that stocks are outperforming bonds, even if both markets are falling. Notably, this history over the past decade shows that there have been periods of treading water followed by a resumption of the rising trend. We’re currently in another period of moving sideways (with a modest downside bias). In other words, bonds are losing less than stocks year to date. Note, too, that the recent uptrend has been unusually dramatic, which implies that stocks have been overheated relative to bonds. What happens next could be telling. We may be in a new regime of rising rates and so monitoring how this ratio evolves deserves short-list attention.
Inflation-Indexed US Treasuries (TIP)/US Treasuries (IEF): This pair is useful for monitoring the reflation/inflation vs. disinflation/deflation trend. As the next chart below suggests, disinflation/deflation have been the dominant theme for much of the past decade. But this long-running trend seems to have ended in early 2020. Either that or the sharp rebound in the TIP/IEF ratio is giving a good impression of regime change that’s shift toward relfation/inflation.
US Small-Cap Stocks (IWM)/US Large-Cap Stocks (IWB): The long-suffering theme of small-cap equities has seen several false dawns in recent years. When the line in the chart below is rising, that’s an indication that small caps (IWM) are outperforming large caps (IWB). But as the generally declining drift suggests, small-cap outperformance has been a hit-and-miss affair at best in recent history. The main exception is the sharp runup in late-2020, which inspired a wave of forecasts that the great age of small-cap outperformance had finally arrived. Last year’s reversal of fortunes, however, disabused the crowd of that prediction and, as a result, we’re still waiting for a sign that the tide has turned toward small caps.
Emerging Markets stocks (VWO)/US stocks (SPY): Here’s another familiar narrative in the land of pursuing higher risk premia: emerging markets (VWO) offer higher expected returns vs. developed market stocks. Compared against US stocks (SPY), however, the past decade has provided thin pickings on that front.
US Consumer Discretionary Stocks (XLY)/US Consumer Staples Stocks (XLP): This pairing is one of several ways to monitor the crowd’s risk appetite, or at least in relative terms within the US equities space. The assumption is that when investors are in a risk-on frame of mind, the XLY/XLP ratio will be rising, as it has been for much of the past ten years. For risk-off, the bias shifts to holding relatively safe stocks via consumer staples and during those periods the line will fall. Not surprisingly, the line has been tumbling for most of the year-to-date run. The jig is up, at least for now. When we see some stability in this ratio, that may be a sign that the big fade for the risk appetite has run its course. ■