The economic cycle provides an outline for which parts of the cycle favor which sectors of the market. And while we are not economists, a cursory historical look has borne out many of the sector-cycle theories. For example, the consumer discretionary sector has often out-performed during the middle of the economic cycle as growth is accelerating. Conversely, consumer staples tend to outperform late in the cycle as the economy slows down. If these trends are valid, like they have been in the past, the relative performance between the two consumer sectors may be sending a warning sign right now regarding the economy. As of yesterday, the ratio of consumer discretionary to consumer staples stocks hit an 18-month low.

This ratio, which we calculate using the Consumer Discretionary SPDR ETF (XLY) and the Consumer Staples SPDR ETF (XLP), reveals the recent strong outperformance on the part of staples versus discretionary stocks. If the economic cycle theory is correct, this is not a welcomed development for the market or the economy. There is nothing magical about the 18-month duration. We mention it because that was the low that was reached yesterday. It just turns out that historically, the market has not fared well after reaching that milestone.

The discretionary/staples ratio has reached an 18-month low on 4 prior unique occasions since the SPDR’s began trading in 1998. Stock performance afterward was not favorable, to say the least:

• September 26, 2000: The S&P 500 moved sideways for a week, then failed to close higher for over 6 years. The Discretionary SPDR (XLY) traded in a sideways range for the following 3 years. The Staples SPDR (XLP) rallied 20% into the end of the year before declining over the subsequent 2+ years.
• July 7, 2006: The S&P 500, XLY and XLP all dropped for a week before rallying strongly for at least the next 12 months.
• November 2, 2007: The S&P 500 scored 2 higher closes during the month, then failed to close higher for 5 ½ years. XLY scored precisely 1 higher close over the following 3 years. XLP rallied 5% over the next month before trading sideways for 10 months.
• June 30, 2008: The S&P 500 and XLY went sideways for 2 months before crashing 50%. XLP rallied 10% over the next 2 months before crashing by over 30%.

Obviously, the timing of 3 out of the 4 precedents was extremely inauspicious. Again, there is nothing magical that we know of about 18 months. But we would take the general weakness on the part of discretionary stocks versus staples as a warning on the economy and the market.

This is particularly so given the 50% drop in the price of oil. Economists also tell us that such a drop is tantamount to a tax cut and should lead to more consumer discretionary spending. Perhaps it is too soon to see much of that benefit in the economic data. However, if it were true, the benefits should be playing out already in the great discounting mechanism that is the stock market. At the risk of putting on our economist’s hat, the fact that discretionary stocks are not outperforming now suggests that the drop in oil (and lackluster discretionary spending) is more a function of weak demand than it is a supply issue (economist’s hat, off).

Perhaps the market and discretionary stocks will pull a July 2006 head fake on us and start screaming higher. We certainly understand the “upside blowoff” case for stocks and see a possibility there. However, from a risk/reward standpoint, we prefer to go with the odds when investing. Those odds tell us that weakness in the consumer discretionary sector versus staples is flashing a warning sign for the economy and stocks.

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Read more from Dana Lyons, JLFMI and My401kPro.