Inflation, Business Cycle And Sector Rotation - Domino Effect And Investment Opportunity

| About: SPDR S&P (XOP)

Summary

Commodities as historically the most reliable and steady inflation indicator are signalling a long-term Inflation Cycle.

Based on the inflation assumptions, business cycle and sector rotation theory is signalling that we are in stage 5 of the  business cycle, favoring the basic materials and energy sectors.

Cyclical, technical and sentiment market factors are confirming the business cycle theory and sector rotation assumptions.

My pick for the business cycle play is the S&P Oil & Gas Exploration & Production ETF outright with a hedge or spread against the S&P 500.

Introduction

There is a growing concern and developing market consensus that inflation is on the rise and that we are in a late phase of the expansion cycle, lead me to revisit the business cycle theory and implications on the sector rotation. Results based on technical, sentiment and inter-market analysis were solid, simultaneous, and timely. My long pick (outright, outright with hedge, or spread against the S&P 500) with detailed trading structure for this market environment is the S&P Oil & Gas Exploration & Production ETF (XOP).

Commodities as historically the most reliable and steady inflation indicator.

Commodities are historically the single most reliable and steady inflation indicator because commodity price inflation tends to appear very quickly and precede consumer price inflation as staples of human consumption. It is also the most critical and uncertain part of the link with business cycle and sector rotation. Using the longer-term commodity cycles (as illustrated in the charts below) matches the inflation cycle and also takes out the shorter-term volatility related to commodity supply and demand shocks (weather, geopolitical, etc.) and liquidity issues (speculation, hedging, etc.).

Long-term cycles of major commodities are in sink and simultaneously bottoming along with rising correlations between them. We did not see this pattern in decades.

The long-term comparison price chart below of gold (GLD), copper (JJC), crude oil (USO) and the broad commodity index (GSG) shows that we are at this infliction point since Q1 of 2017 for gold and copper and since Q4 for general commodities and crude oil.

Comparison Commodity Price Chart - Courtesy of TD Ameritrade ThinkorSwim


The Median CPI on the chart below (green line) is signalling a development of a bullish cycle (bottom Elliot Wave indicator) and potential break of the upper regression channel (red lines) with potential Fibonacci price (horizontal cayenne lines) and time targets (vertical magenta lines) of 3% by early 2018 and 4% by 2022. Overlay is the University of Michigan Inflation Expectations Index (yellow line) which is very volatile and lagging with no predictive or analytical value. Conversely, The CPI Index as the conventional inflation indicator is static and outdated, while central banks inflation target under 2% is highly questionable. To make things worse, the inflation expectation of the financial markets is surprisingly complacent and very low.

Courtesy of TD Ameritrade ThinkorSwim

Beginning of an Inflation Cycle and the Business Cycle assumptions.

The graph below shows the idealised business cycle and the inter-market relationships during a normal inflationary environment, where based on the inflation expectations and business cycle assumption, we are at the doorsteps of business cycle stage 5.

Business Cycle Map - Courtesy of Stock Charts (StockCharts.com | Simply The Web's Best Financial Charts)

Sector Rotation in Business Cycle Stage 5 favours Basic Materials and Energy Sectors.

Unsurprisingly, the business cycle influences the rotation of stock market sectors and industry groups, where certain sectors perform better than others during specific phases of the business cycle. In this phase of the business cycle the best performing sectors should be basic materials followed by energy.

Sector Rotation Chart - Courtesy of Stock Charts (StockCharts.com | Simply The Web's Best Financial Charts)

The mid-term chart below shows that basic materials have been very correlated and just slightly under-performed the S&P 500, while the energy sector broke the correlation and significantly under-performed the S&P 500 in 2017. Both sectors are showing price/money-flow strength and signalling potential out-performance against the S&P 500 in 2018. Basic materials sector preceding the energy sector in price strength and cyclical reversal is a very strong signal and in line with the sector rotation theory.

Courtesy of TD Ameritrade ThinkorSwim

I think that energy sector and selected industry groups within the energy sector are a better choice for trading and investing - given the under-performance and technical factors.

Analysis and Price Forecasts for the S&P Oil & Gas Exploration & Production ETF.

My pick from the Energy Sector universe - based on index/constituents, trading opportunity and liquidity, is the Oil & Gas Exploration & Production ETF. However there are several other industries and dozens of stocks in the Energy Sector that can qualify.

The two charts below are the mid-term outright chart of the Oil & Gas Exploration & Production ETF and the mid-term spread adjusted charts against the S&P 500 Index - where three key points come to mind:

  • Spread Chart - Recent spread out-performance by the S&P 500 was on weak money-flows and starting to build strong resistance; Relative Strength and Money-flows showing signs of divergence and potential spread reversal.

S&P 500 Trust ETF -S&P Oil & Gas Exploration & Production ETF, XOP - Courtesy of TD Ameritrade ThinkorSwim

  • Outright Chart Indicators - Relative Strength and Money-flows showing signs of positive divergence and Cycle indicator showing a potential start of a new up cycle.
  • Outright Chart Patterns and Price Levels - Target price around $45 where three factors are in play - Strong resistance from 12/12/2016 High of 44.97, 38.2% Fibonacci retracement (cayenne line) of $45.6 between 6/14/2014 High and 1/18/2016 Low, and 6 month 1 Standard Deviation high price of 44.31 (green line). Support price around $30 where two factors are in play - Strong support from 8/21/2017 Low of 28.96, and 6 month 1 Standard Deviation low price of 30.5 (red line).

S&P Oil & Gas Exploration & Production ETF - Courtesy of TD Ameritrade ThinkorSwim

Trade Options and Ideas for XOP.

Given the opportunity outline above, there are many attractive options to structure a trade: outright, outright with a hedge, and spread - where my pick and focus is on #3 Buy XOP hedged.

  1. Buy outright XOP with a 3 to 6 month target at 45
  2. Buy Spread/Pair Long XOP, short equal $ weighted S&P Futures or SPY (this trade can be further $ and historic volatility adjusted).
  3. Buy Outright XOP with a 3 to 6 month target at 45, hedged with the SPY June-15 265-249 Bearish Put Spread.

Number 3 is the most superior strategy because the bearish put spread acts as a spread to outperform the S&P 500 and worst case scenario in case of sector or market downturn - all for a small premium. Let's say you purchase 1350 shares of XOP which equals to about $50,000 exposure and you buy 8 contracts of 265-249 bear put spread for $2,720 (3.40 mid point) debit - June 29 expiration because this is a maximum time horizon for the trade, 8 contracts at 265-249 price spread because this is the most optimal spread and hedge combination without paying too much premium - given a negative implied volatility skew which is typical for stocks and stock indexes (buying a relatively cheaper option at 10.39% implied volatility and selling a more expensive option at 14.52% implied volatility).

While the P&L's for the outright purchase of XOP is straight forward - First chart below calculates the P&L of the S&P 500 bearish put spread; Second chart below calculates the probable P&L of the entire trade with the hedge, solely on the movements of the S&P 500; Third chart below calculates the probable P&L of the entire trade with the hedge, solely on the movement of XOP. As conclusively shown in second and third charts, little is taken away by premium in profits from the upside potential, and the downside is mostly protected ' if not fully protected or even income enhanced from adverse down moves in the S&P 500 or the XOP.

Risk Profile - S&P Oil & Gas Exploration & Production ETF and S&P 500 Trust ETF Hedge Price Range Scenarios - Courtesy of TD Ameritrade ThinkorSwim

Light Gray background - 6 month +/-1 Standard Deviation Price Range
Cayenne line - P&L's at expiration Magenta Line - P&L's at current

Conclusion

The cause and effect between inflation, business cycles and sector rotation is a solid long-term theoretical concept, however in real life investing rarely does it give us a clear and timely picture - especially the inflation part of the puzzle as the most critical and uncertain. Nevertheless the cyclical, technical and sentiment market factors are signalling that the market consensus and the underlying theme are developing in this direction, where profitable trades and investments can be made on the back of the business cycle and sector rotation theories.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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