Are We Seeing The Early Sign Of A Change In Market Leadership?

• The Inflation/Deflation ratio
• Lagging sectors
• Defensive sectors

The Inflation/Deflation ratio

Last week I charted my Inflation/deflation ratio for the first time in a while and was surprised to see that it had broken to the downside. For those unfamiliar with the concept, the Inflation Ratio (!PRII) consists of S&P sectors that have a tendency to do well at the end of the cycle when commodity prices are running and manufacturing is tight. They are sometimes referred to as earnings driven and include basic industry and resource oriented companies. The Deflation Index (!PRDI) comprises defensive and interest sensitive issues, such as Utilities, Telecom REITs and Consumer Staples. These are otherwise referred to as liquidity driven issues. They tend to do well when the Fed is injecting liquidity into the system during the latter phase of a recession.

When charted separately these two indexes do not tell us that much. However, when expressed as a ratio they offer a substantial amount of information.  Take Chart 1, for instance, where the ratio is being compared to the CRB Composite, and where we see a fairly close relationship. That’s not surprising really, because it’s the stock market’s way of telling us whether investors are favoring inflation or deflation hedge stocks. It’s important to note that this is a general comment, and does not mean that every inflation sector will do well when inflation sensitives are doing well and vice versa. It just tells us to be on the lookout for earnings driven sectors and stocks in general but only take action on a trust but verify basis.

The paths of the two securities in Chart 1 are not identical, but for the most part, they do seem to move in a similar direction. If anything, the ratio appears to lead commodity prices at major turning points at both tops and bottoms, hence the slanting green and red arrows. Also, when both series violate trendlines, as they did in mid-2014, this offers a useful inflationary or deflationary signal, depending on the direction of the break. Having established, say an inflationary signal you would then drill down to earnings driven ETF’s or individual stocks.

Chart 1

Somewhat counterintuitively to the recent 4.1% GDP number, the Inflation/deflation ratio has crossed below its 12-month MA and 2016-18 bull market trend line. If the signal is valid, that means that liquidity driven sectors are likely to out-perform their earnings driven counterparts. If the relatively close relationship between the ratio and the CRB continues, and I have no reason for suspecting otherwise, that would also imply that the CRB will soon break below its up trend line. This change in leadership may indicate a more defensive posture by investors as a prelude to a more generalized retreat in prices. I am assuming that the trend is still up, but if the S&P drops below its 12-month MA that would be quite negative form a long-term perspective.

Chart 2 shows the ratio, together with its short- and long-term KST’s. You can also see that it has crossed decisively below its 65-week EMA. It seems likely therefore, that a change in leadership is underway, where the recent improvement by defensive issues is likely to continue.

Chart 2

Lagging sectors

The earnings driven SPDR Basic Industry ETF (XLB) looks to be consistent with the downside break in the Inflation/deflation ratio as its RS line, in the third window of Chart 3 has broken down along with its relative KST in the bottom panel. The price itself remains in an uptrend, though the long-term KST for the absolute KST has started to roll over to the downside.

Chart 3

The SPDR metals and Mining ETF (XME) is featured in Chart 4. It is clearly in a fine state of technical balance, which leans to the bearish side as both KSTs are negative.

Chart 4

Chart 5 which covers the short-term aspects, argues that that fine balance will be resolved on the downside. That’s because both the price and RS lines have violated trend lines.

Chart 5

Chart 6 gets into the trust and verify category as energy, in the form of the SPDR Energy ETF, which  should be looking weaker due to the deflationary break in the Inflation/deflation ratio. However, at this point both KSTs are in a bullish mode and the price and RS lines are in a long-term uptrend.

Chart 6

Defensive sectors

Arguably the strongest candidate for long-term gains is healthcare, which is generally regarded as a defensive sector. Relative strength wise, Chart 7 tells us that the XLV has been correcting since mid-2015, but is now trying to edge through a 3-year down trend line. Since the long-term KST for relative action is positive, it’s likely that healthcare can extend its recent leadership role.  The KST for the price itself is also bullish but the price may be running into resistance in the form of the early 2018 high.

Chart 7

Chart 8 shows that the SPDR Utility ETF (XLU) remains in an uptrend, but its long-term KST is not. Relative action is all over the place in a giant trading range. The KST is stabilizing but has yet to turn. The green arrows show that even in the trading range previous long-term relative KST signals have been associated with a relative rally (July 2010 excepted). Given the stronger showing by the Deflation Group Index I would have expected more than this neutral relative action.

Chart 8

After a 2016-early 2018 sell-off, the RS line for REITS, in the form of the iShares Real Estate ETF (IYR), has now managed to break above a major down trend line as well as its 65-week EMA. The long-term KST for relative action has started to turn up slightly, but it’s still bearish. However, the loss of downside momentum indicated by the trend line break should ensure a bullish KST signal before long. The IYR itself has just registered a new bull market high which, supported by improving relative action, should propel things even higher.

Chart 9

Finally, Chart 10 shows that the iShares Consumer Services. It contains  retail oriented stocks from the discretionary and staple universe and recently broke out from a huge relative strength base. Since then the absolute price has gone on to register a new bull market high.

Chart 10

It looks a lot stronger than the SPDR Consumer Staple ETF (XLP), which is still cursed with two declining long-term KSTs.

Chart 11

This month, the Market Roundup carries a lot of information about how acute the current market position is in globally.

Good luck and good charting,
Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group of Walnut Creek or its affiliates.