Both market optimists and doomsayers are out in full force following the recent economic data.
Their goal is to determine whether the stock market is headed for a boom or bust.
And there’s plenty of evidence for either camp.
The payrolls report for January showed that 517,000 jobs were created – that’s more than double economists’ estimates. This suggests a “soft landing” for the economy where a recession is avoided.
But that puts pressure on the Federal Reserve to keep raising interest rates in a bid to cool the economy and keep lowering inflation. We saw how stocks responded to that last year with a 19% drop in the S&P 500.
For investors, it might seem like a coin flip to know which camp will prevail.
But instead of turning trading into guesswork, there’s a better way to discover a clearer picture of where things are heading.
You just have to sift through the clues being left by the stock market… because buried within the market’s sector trends, price is telling you what lies ahead.
Follow the Leaders
The stock market is a discounting mechanism for future business conditions. That means the market typically turns before key inflection points in the economy.
And just as the market can reflect the state of the economy, certain sectors can tell you about the health of the stock market.
For example, last year it was defensive groups like consumer staples leading the way. When companies that are known for being recession-proof are holding up the best, it can be a bad sign of things to come.
You can see that in the chart below, which plots a ratio of consumer staples stocks against the S&P 500…
A rising line means staples are outperforming, and vice versa.
You can see that consumer staples took the lead and crossed above the 200-day moving average (MA – orange line) back in January 2022 just as the bear market got underway (red circle).
Just like how defensive groups can signal a bad market incoming, there are industries sensitive to positive developments in the economy.
When they perk up, it can be a good sign of things to come for stocks.
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The Message from an Economic Bellwether
Companies in cyclical areas of the economy can deliver timely insights about the stock market. It’s also a way of evaluating markets that’ve been around for a hundred years.
You might have heard of something called “Dow Theory”…
It’s a framework built on the research of Charles Dow, who in the late 1800s would confirm (or deny) bullish action in the stock market by looking at railroad companies… a new and innovative industry at the time.
The rationale is simple. Good times coming for the economy would surely be reflected by railroad stocks discounting a boost in profits ahead.
These days, semiconductor (or chip) companies are among those most sensitive to changes in the economy. That’s because chips are the building blocks of our electronic devices.
To see what I mean, take a look at what’s been happening in the chips sector. The chart below shows the ratio of chip stocks to the S&P 500…
After bottoming in October, chip stocks have outperformed the S&P 500 and sustained a crossover above the 200-day MA in early January as the market was heating up (red circle).
So, while warning signs over the economic outlook are abundant, the message coming from the stock market is clear.
The trend of rallying stock prices is being supported by the right sectors, and signals more gains are in store.
Best regards,
Clint Brewer
Analyst, Market Minute
Reader Mailbag
In today’s mailbag, a Currency Trader member shares their experience…
I am excited about trading the Currency Trader. I have done options, but they are expensive for me, and I’m happy to hear I can start low and build up. I believe I can trust what you say, and I’ll follow your instructions. Thank you and have a great weekend.
– Bobby H.
Thank you, as always, for your thoughtful comments. We look forward to reading them every day. Keep them coming at [email protected].