The Consumer Staple ETF (XLP) continues to reach new highs and outpace the S&P 500, is it time trade against the grain and short the fund's top holdings of Procter & Gamble (PG), Phillip Morris (PM), Coca-Cola (KO), and Wal-Mart (WMT)?
The Consumer Staple ETF is way up year to date, nearly 15% as of Monday's close. Investors in this space should be wary of the high relative strength to the market, as well as the record low volatility in the broad market. Both of these issues can forebode negative price action. Owners of the ETF are not the only ones that should consider selling into this strength, owners of the fund's top holdings find themselves in a similar gluttonous position.
Despite a stronger economy and even a bullish outlook on equities, the below stocks are ripe for a pullback. There are simply better opportunities available for investors elsewhere with less downside potential. The potential for a pullback is growing in the market and an overbought space is not kind to investors during such an event. The top four holdings in the fund are also either overbought and/or have disturbingly low short interest. Short interest is a good judge of investor sentiment and in an open market, sentiment is as important as fundamentals. Low short interest can be a good indication that prospects are good for a company, but it simply means there is a low amount of shares sold short. The fact that a low amount (or percentage of float) of shares are sold short does not defend investors on a pull back. In fact, extremely low short interest can indicate a price top. These top holdings are not bullet proof and investors should continue their long positions with caution and consider taking profits at these levels. Taking short positions against the strength of these names is unpopular but can be profitable during a pullback as we risk hearing weaker earnings in April.
XLP Holdings are Overbought
The XLP relative strength index value (10, 1w) has been over 90 since the first week of March, indicating it may be ripe for a pull back more significant that last week's. Despite weakness late last week, shorter term RSI (10, 1d) for the top XLP holdings are as follows: Procter & Gamble (63.38), Phillip Morris (70.14), Coca-Cola (60.85) and Wal-Mart (96.88). The RSI for the fund seems to be predicting a pullback for this highly regarded, defensive sector ETF. Two top holdings significantly substantiate (Phillip Morris and Wal-Mart) the concern in the fund with very high RSI levels.
Utilizing RSI values is a great way to consider momentum, and based on their RSI values, this could mean that Procter & Gamble and Coca-Cola could still have room to run. Unfortunately, they will be subject to headwinds as investors in the same sector unwind their holdings and take profits since the fund and other top holdings have already reached overbought levels. While RSI values alone are perhaps incomplete evidence, when combined with historically low volatility, the undaunted advances of the fund and its top holdings that have phased short sellers nearly out of the picture become more of a concern.
Low Potential for Further Upside
Extremely low short interest can indicate a price top for indexes and stocks, primarily because short squeezes no longer boost stocks after short sellers cover. The market has seen bullish momentum despite other bearish events and data like Cyprus banking headlines and short sellers have slowly started throwing in the towel. However, many are shouting that this momentum deserves a breather. Even though many believe in a longer term bull market, they should know markets are not immune to corrections. Low volatility (consistent one-way price action, in this case, upward movement) and low short interest (small portion of sellers of the stock) which are basically bullish sentiments can represent a contrarian indicator when fundamental data disconnect from bullish momentum. In other words, investors can become comfortable with a status quo where prices consistently increase and even short sellers can dismiss threats. For instance, low volatility levels we see today are reminiscent of the low volatility environment preceding the last US stock market crash in 2009.
Short interest is typically interpreted as a rear-view mirror indicator because it is released twice a month and while an accurate picture of the amount of shares sold short, it is released about a week after measurements are recorded. That stated, the metric is important as it measures the sentiment of a stock, typically interpreted as appropriately priced with bears fearful to short the stock due to stability. However, low short interest amid low volatility as well as overbought levels can spell pullback with a capital 'P.' Short interest is better measured as a percentage of the shares outstanding or float, as changes in shares sold short are meaningless if outstanding shares change by the same percentage (an unlikely but possible scenario). SIPF for the top holdings of the XLP are as follows: Procter & Gamble (0.92%), Phillip Morris (0.74%), Coca-Cola (0.81%) and Wal-Mart (2.07%).
This low volatility environment indicates that we as investors see enough strength in the market to push past threats and risks with reckless abandon, the tall RSI values support the fact that investors have been chasing highs in the XLP and finally the very low short interest of the top holdings in the XLP indicate that even short sellers have been bullied out of their positions. The layman might perceive each of these factors individually and consider them as bullish information but when taken in aggregate, the assessment is that investors have been ignoring the possibility of a pullback - precisely when one is most likely. While this is not necessarily a bearish call, investors should consider the likelihood of moves back to 50-day moving averages amid the data presented. If this reversion to were to occur, the resulting percent decreases from yesterday's close would be painful for long positions and profitable for short positions: XLP to $38.13 (-4.9%), Procter & Gamble to $76.48 (-2.9%), Phillip Morris to $90.30 (-4.4%), Coca-Cola to $38.51 (-5.8%) and Wal-Mart to $71.93 (-6.9%).
The potential for moves lower should not be ignored but returns to 50-day MAs are likely with strength following the pullback. This is a play on overvalued stocks, not a bear market. If short positions are taken, they should be closed near the 50-day MA and picking up naked calls at that level will benefit from any bounce and short squeeze that follows. With earnings announcements and guidance playing a strong role in the market dynamics in the week ahead reassessing these names is important, at these levels they do not seem as stable or defensive as they are thought to be.
Additional disclosure: I am not a professional advisor; my interpretations of the market are independent and should not be construed as advice.