We’re always looking for different ways to measure the animal spirits responsible for driving markets higher or lower. In many cases, we do this by examining the risk appetite of one asset class relative to another through a variety of intermarket and ratio analysis.

Today we’ll look at the oft-cited Consumer Discretionary Sector SPDR ($XLY) vs. Consumer Staples Sector SPDR ($XLP) ratio and illustrate how due to the cap-weighted nature of these ETFs, this ratio might not be as effective as a risk-appetite indicator as many believe. This is because the Large Cap Sector SPDR ETFs, which we often use as benchmarks for the various S&P sectors, are often dominated by just one or a handful of mega-cap stocks. In the case of XLY and XLP, the funds two largest holdings, Amazon ($AMZN) and Procter & Gamble ($PG) comprise 24% and 16% of total assets, respectively. For this reason, XLY/XLP looks nearly identical to a ratio chart of AMZN and PG. As shown in the overlay chart of the two ratios below, this is not just a short term phenomenon. The relationship has been solid over history.

The point is, this is not painting an accurate picture of risk-appetite among these two sectors, it is merely showing us the relative performance between two of the world’s largest conglomerates. Not to mention, regardless of the asset, it hasn’t been easy to outperform AMZN, as evidenced by the strong structural uptrend in these ratios for over a decade now.

When using the Sector SPDR ETFs for any kind of analysis at all, it is important to keep in mind their cap-weighted nature paints a picture of what the largest stocks in the US are doing, but not so much what the average stock is doing. When analyzing risk-appetite, we need to be careful that we’re observing sets of data that represent broad participation within the asset classes we’re comparing. It would not be fair to conclude that risk-appetite has been roaring for the last decade just because AMZN has steadily outperformed PG, would it? Plot AMZN against anything, and you’re going to see an uptrend.

For this reason, we prefer to use equal-weight indices such as the Invesco ETF series, which offer both an Equal-Weight Consumer Discretionary ($RCD) and Equal-Weight Consumer Staples ($RHS) ETF. When you plot these against one another, it provides a much different picture than XLY/XLP. Here it is.

Instead of a long-term uptrend like we have in XLY/XLP, which has doubled over the past 10-years, the equal-weight ratio has more or less gone nowhere over the same period.

Just as it is always important to understand what you own as an investor, as an analyst, it is imperative to understand the composition of the assets you’re analyzing as this will provide insights and allow you to ensure you are working with the right data. In the case of XLY/XLP and most ratio analysis using the Sector SPDRs, the data is not very effective as it is just analyzing the performance of the biggest players in each sector against one another. We believe the equal-weight ratio is the best representation of risk-behavior, and right now, the signal is mixed, which is similar to what we’re currently seeing in most risk-appetite measures.

I hope you enjoyed this post! As always, reach out to me at Strazza@thechartreport.com with any questions or comments.