Updated: Jan 28, 2021
I came across this article on Seeking Alpha recently which talks about the concept of using consumer spending to better understand the movement of the stock market. If you are a paid subscribed member of Seeking Alpha, you may like to read the linked article in full. In this post, I will be highlighting a few key concepts related to this and provide a concise summary to this concept exploration.
The consumer spending accounts for 70% of the US Gross Domestic Product (which in turns describe the economy). Hence, how the US consumer spends seems to be able to have a huge impact on the movement of the stock market ultimately since that is a usually a byproduct of the economy. Is this really the case? Let's find out a bit more as described in the article.
There are a few ETFs which describe the consumer spending. In this study, we will be looking at two specific ETFs- RCD and RHS. RCD represents Invesco S&P500 Equal Weight Consumer Discretionary ETF. Generally, it tracks the equal-weighted index of large cap US Consumer discretionary stocks from the S&P500. For the uninitiated, discretionary stocks refer to cyclical stocks which represent companies that produce non essential products and services which consumers may exercise more discretion in purchasing during tough times (eg. current pandemic). Examples of the holdings in this index include Etsy, Gap and Tiffany & Co.
RHS represents Invesco S&P500 Equal Weight Consumer Consumer Staples ETF. Generally, it tracks the equal-weighted index of large cap US Consumer staple stocks from the S&P500. Staple stocks refer to stocks which represent companies that produce essential products and services which consumers will still continue to purchase during tough times. Examples of the holdings in this index include Walmart, Campbell Soup Company and Costco Wholesale Corporation.
In the Seeking Alpha article highlighted above, a metric based on the ratio of RCD/RHS is derived and used to understand generally how the companies which are producing discretionary goods and services are faring in comparison to the companies which are producing essential products and services. From this metric, a certain moving average value is obtained and the metric is compared against this moving average value to determine the trend characteristics of the metric. For instance, if the ratio of RCD/RHS falls below the moving average value, it could be a bearish sign as it could signify a considerable drop of consumer spending in discretionary products/services as compared to essential products/services. Similarly, if the ratio of RCD/RHS rises above the moving average value, it could be a bullish sign as it could signify a considerable rise of consumer spending in discretionary products/services as compared to essential products/services.
To give a little bit of visual context on how this could look like, here is a graph comparing the ratio of RCD/RHS value against its 70-day moving average for the ratio of RCD/RHS for the period from Nov 06 till now.
The green line represents the ratio of RCD/RHS, while the yellow line represents the 70-day moving average for the ratio of RCD/RHS. Please take note that I choose a 70-day moving average as it seems to give me the best results out of the other durations (eg. 100 days, 50 days etc).
Now, let's take a look at significant moments in this 14 years period to determine if the movement of RCD/RHS across the moving average could be used as a reliable indicator for the stock market.
In the course of the past 14 years, I believe there are two key events in the stock market which stands out. The first one is the Global Financial Crisis which happen in 2008/9 period and the other one is the big drop which we all see in the market in 2020. You could see from the graphic above that the indicator was quite a reliable one in the previous market crash. The RCD/RHS ratio starts to fall below the 70-day moving average in July 07, and you have the market hitting its peak just three months later- which then triggers the bear market afterwards. Throughout the whole bear market, the ratio did make a few attempts to beat its moving average but there is no significant breakout until Mar 2009 where the bottom of the bear market is seen. If you are to rely on this indicator during the previous crash, you are likely to do well in the market.
In the more recent crash in 2020, the RCD/RHS ratio already starts falling below the 70-day moving average in January 2020, which is two months before the dreaded big drop in the stock market in March 2020. In this case, this indicator seems to be rather good in foreshadowing big drops in the market as it did the same in 2009. The RCD/RHS ratio then starts climbing above the 70-day moving average again in May 2020. In this case, there is a certain lag as the stock market has already stock recovering in late March 2020.
Overall, I would say that this indicator is a pretty good one. While it might not be perfect in determining the exact peak/trough of the stock market, it sure could help us in avoiding the big and significant drops in the stock markets- at least for what had happened in 2009 and 2020.
For the earlier readers, you all might have came across an article which I wrote a few months ago on the use of data science to better understand trend investing so you could anticipate a buy/sell/hold decision in the stock market. In the model created, features such as SMA 20, SMA 50 etc are used with the objective of predicting buy/sell/hold. The model has been churning out strong sell signals ahead of the September drop and allows me to use it as one of the indicators in better understanding/anticipating market movements. Moving ahead, I will include the RCD/RHS ratio and its moving average value in my data science model to better the results. Based on some forms of backtesting, inclusion of these new indicators seems to be able to improve the results of the confusion matrix (predicted vs actual).
If you are interested in understanding what are the weekly recommendations churned out by the model, do sign up as a patron in the link below as this information will be updated on a weekly basis.
Of course, disclaimer ahead: Do remember this is not professional financial advice.
Last but not least.. please scroll down and subscribe for regular content if you like what you read!