Consumer Staples Send Up a Rare Signal

The following is a reprint of the market commentary from the July 2018 edition of The Option Advisor, published on June 22. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- visit our online store.

The underperformance in consumer staples stocks this year has been, to phrase it mildly, pronounced -- even as consumer spending figures remain unusually robust (up nearly 6% year-over-year in May, per government data). On a year-to-date basis, the performances by major U.S. equity benchmarks range from flattish (the Dow) to slightly higher (the S&P 500) to firmly higher (the Russell 2000 and Nasdaq Composite); meanwhile, the Consumer Staples Select Sector SPDR Fund (XLP) has dropped by more than 10% in 2018, as of this writing.

The dismal performance of the "staples" group is sharply contrasted by the breakout in the Consumer Discretionary Select Sector SPDR Fund (XLY), which has rallied about 14% since the start of the year. The dichotomy here is easily explained by a quick skim of the top holdings for each fund. While Amazon, the tech/retail hybrid powerhouse, accounts for nearly 24% of XLY's weight, the top holdings for XLP read like a "who's who" of the innermost aisles of your neighborhood grocery store.

In that regard, the XLY/XLP comparison is not quite a fair fight, as it's been remarkably hard to compete with Amazon on any front in 2018 (given that the online retail monolith has expanded its market cap by upwards of $280 billion on a year-to-date basis). But even compared to the fairly staid performance of the S&P 500 Index (SPX), XLP stands out as a laggard. The exchange-traded fund (ETF) has registered a relative-strength reading of less than 0.85 versus the SPX for 48 consecutive trading days -- an "underperformance streak" the likes of which has been recorded only one other time, in March 2000.

Simultaneously with this historic degree of underperformance on the part of consumer staples, our recent studies on the subject have countered the conventional wisdom on small-cap leadership serving as a reliably bullish sign for the market -- and in fact, the results have instead suggested that previous comparable instances of "small-cap leadership" have actually heralded S&P weakness over the intermediate term. In light of this, you might say that our "antennae" have been up for any other notable divergences between various market benchmarks.

And commensurate with the longstanding reputation of consumer staples as a traditionally "defensive," non-cyclical sector, XLP often delivers its strongest performances -- relative to both the broader S&P and its close cousin, XLY -- during economic downturns, as consumers opt for grocery store goods and discount retailers over restaurants and coffee shops. With this in mind, the marked weakness in XLP of late relative to the S&P effectively piqued our interest, and the wide gulf between XLP and XLY returns cemented our intrigue. If consumer staples thrive during recessions while consumer discretionary stocks slip, could the reverse scenario we're seeing now be a sign of an overly "frothy" stock market?

In previous instances where XLP's relative strength versus the S&P has fallen below 0.85, the average S&P returns over the next six-month and one-year time frame have lagged the norm, per the table below. (This analysis by Schaeffer's Senior Quantitative Analyst Rocky White considers one signal every month, going back to 2000.) The six-month returns are particularly weak relative to the S&P's "anytime" performance, looking at both the average return and the percentage of positive returns. And since this latest signal flashed on April 10, that six-month time frame roughly corresponds with the May-October period that we've already established as being the weakest six months of the year for the stock market.

Drilling down on the last time XLP's relative strength reading stayed below 0.85 for such a long stretch, the month of March 2000 may ring a bell, as it coincided with the Nasdaq Composite's dot-com peak. Following the XLP underperformance signal in that month, the S&P actually went on to comfortably surpass its "anytime" returns over the next one-month, three-month, and six-month time frames -- but by the time the one-year mark rolled around, the bottom had fallen out for the benchmark equity tracker.

And while a single previous occurrence should not by any means be considered an accurate predictor of future results, we'll leave you this month with an observation from our recent commentary on a similarly foreboding bond yield signal that just occurred for the first time since September 2008: "On the one hand, this is an expected limitation of such a small sample size, and reason to consider these past returns with a healthy dose of skepticism and a critical eye. And on the other hand, it would be ruthlessly optimistic to overlook the fact that the last such signal preceded a major disruption in the global financial system, along with a historic bear market for U.S. equities."