Welcome To The Great Re-Adjustment

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Includes: EEM, EFA, IPE, JNK, SLY, SPY, TLH, XLB, XLC, XLE, XLF, XLI, XLK, XLP, XLRE, XLU, XLV, XLY
by: Michael A. Gayed, CFA
Summary

It’s been all about trade over the past week.

The unexpected turn of events resulted in investors removing risk from their portfolios and fleeing to safe havens such as utilities and Treasuries.

Continued weakness in materials prices could be a signal that further downside is still ahead, further the potential for a Spring Crash.

“All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.” - Arthur Schopenhauer

This is the Lead-Lag Report for 5/16/19. A comprehensive version of the weekly Lead-Lag Report with trade signals based on award-winning papers will be available on Seeking Alpha for subscribers in early June.

Below is an assessment of the performance of some of the most important sectors and asset classes relative to each other, with an interpretation of what underlying market dynamics may be signaling about the future direction of risk-taking by investors. The below charts are all price ratios which show the underlying trend of the numerator relative to the denominator. A rising price ratio means the numerator is outperforming (up more/down less) the denominator.

LEADERS: BIG ROTATION INTO DEFENSE AND SAFETY

Financials (XLF) – Hanging Tough

Comments: Financials tend not to be the best late economic cycle investment but the combination of strong GDP and low interest rates has so far muted the impact of global trade concerns. The Fed’s dovish stance continues to fuel optimism that potentially lower rates can keep loan activity growing.

Health Care (XLV) – Returning To Safe Haven Status

Comments: The Medicare For All debate appears to have faded into the background for now and investors have returned to the healthcare sector as a defensive play. A prolonged trade war would theoretically have less of an impact on hospital and pharmaceutical companies which should fuel short-term interest in the group. Be cautious if the Medicare and drug price debates return but for now things are looking relatively positive again.

Utilities (XLU) – Big Rebound

Comments: As expected, investors fled to utilities as a potential trade agreement fell apart. In fact, the utilities sector is the only group to have posted gains over the past week and a half. The market was clearly overly optimistic that a trade agreement was a done deal and is quickly correcting as a deal no longer appears to be in our future. Utilities did well during the 4th quarter correction last year and could be positioned well in 2019 if the trade dispute drags on.

Consumer Staples (XLP) – The Tide Turns

Comments: The consumer staples group has also benefited from the trade dispute. The sector has been forming a base for a few months now and finally crossed back above its 20-day moving average, an encouraging sign for its longer-term prospects. Consumer staples stocks have demonstrated the lowest standard deviation of returns over the past year making them an ideal landing spot for defensive equity investors.

Real Estate (XLRE) – A Bet On Fed Action

Comments: The increased odds of a Fed rate cut by year-end, which has risen from 40% to 70% according to the Fed futures market, has made REIT yields look more attractive. Real estate performance relative to the S&P 500 has returned to a level it’s failed to break through multiple times in the past six months. The combination of lower rates from the Fed and for mortgages improves the bullish sentiment.

Bonds (TLH) – Sharp Turnaround

Comments: Investors made a rapid return to fixed income amidst the global equity selloff although most of the gains have been limited to intermediate - and long-term Treasuries. We said last week that “if tariffs spike at the end of the week and no trade resolution is reached, the rotation into Treasuries could gain steam.” That’s exactly what we’re seeing.

Long Bonds (TLH) – The Rally Rolls On

Comments: While yields on long bonds aren’t particularly attractive here, the prospect of lower rates for longer makes them potentially more profitable for investors. The rally in T-bonds has sustained for six months as yields are dropping to levels not seen since the end of 2017.

LAGGARDS: CYCLICALS GO BUST

Technology (XLK) – Chip Stocks Leading The Rout

Comments: Tech sector leadership in 2019 has officially come to a conclusion as investors unload risk. Chip stocks, which have been leading the market rally this year, are leading the group back down and now sit about 10% off of their highs. Tech had the best earnings beat rate in Q1 with 87% of S&P 500 companies topping estimates but the future will likely be focused on trade.

Consumer Discretionary (XLY) – Fed vs. Tariffs

Comments: The consumer discretionary group has all of the economic tailwinds behind it but tariffs figure to derail further gains. This ratio has been on a month-long downtrend but where it goes from here could depend on whether or not the Fed steps in. A rate cut in the face of tariffs could provide the stimulus necessary to reverse course.

Communication Services (XLC) – Better Positioned For The Trade War?

Comments: This group has taken a hit as well lately but it could be in a position to perform well on a relative basis if the trade war drags on. The sector’s big names, such as Facebook (NASDAQ:FB), Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) and Comcast (NASDAQ:CMCSA), are less reliant on goods that may be subject to tariffs and therefore could be somewhat more immune to a prolonged trade dispute. Since many of the names come from the tech and cyclical sectors, the pullback isn’t surprising.

Industrials (XLI) – The Balloon Is Deflating

Comments: Industrials take a significant hit here as the farming and agricultural industries, particularly soybeans, likely suffer the greatest impact of a trade war. The combination of higher import costs, lower manufacturing activity and weakening fundamentals will likely make it tough sledding for this group going forward.

Materials (XLB) – Better Fundamental View But No Momentum

Comments: The materials sector had one of the better quarters as far as earnings growth but the political and economic landscape continue to work against it. Commodities continue to struggle and worries about manufacturing and spending means lower demand for raw materials. President Trump’s calls for lower oil prices haven’t helped either.

Energy (XLE) – Battling On Several Fronts

Comments: The S&P 500 began pulling back a little over a week ago but the energy sector has been correcting for about a month now. Servicers and explorers are getting hit especially hard as oil prices retreat and crude demand remains in question. The willingness of oil producers to continue cranking out supply will likely put pressure on energy prices going forward and limit some of the energy sector’s upside.

Small-Caps (SLY) – A Risk-Off Pullback

Comments: Just as small-caps started participating in the rally again, the China trade situation sent the group tumbling again. In theory, small-caps should have lesser exposure to overseas economies but the risk-off trade is taking precedent. The price action here still looks ugly overall relative to large-caps and even solid headline economic numbers don’t seem to be helping.

Emerging Markets (EEM) – The Trade War Plunge

Comments: China makes up roughly ⅓ of emerging markets ETFs so it’s easy to see where this plunge came from. The rally this year in Chinese equities, however, hasn’t been able to mask the broader weakness in the emerging markets space as the group trails the S&P 500 by about 8% year-to-date. Despite the fact that emerging markets are cheaper now relative to the U.S. than they have been in many years, it doesn’t look like it will help make the group attractive until we reach some kind of resolution on trade first.

Europe, Australasia, and the Far East (EFA) – Economic Growth Sours

Comments: The story in developed markets is largely the same as it is in emerging markets. A lack of GDP growth and weakness in global manufacturing and energy are driving the narrative. A stronger dollar has also trimmed more than 100 basis points off of foreign equity returns.

Junk Debt (JNK) – Investors Abandon Bond Risk

Comments: High-yield bonds have retreated quickly as investors have migrated to the safety of Treasuries. Adding to the negative sentiment is the fact that high yield spreads are very narrow. There’s little additional return to be had here for the level of risk required. Junk bonds rallied in 2019 despite a relatively poor risk/reward profile but Treasuries have retaken the leadership mantle back.

Treasury Inflation Protected Securities (IPE) – Inflation Worries Not A Prime Concern

Comments: With virtually no concern over inflation and investors looking to capture returns on the long end of the Treasury curve, TIPS have failed to attract much investor interest. Inflation according to some alternative measures looks to be closer to the 2% Fed benchmark but even at those levels it’s still not a key investor consideration at the moment.

Lumber (LUMBER) – Turning Lower Again

Comments: The reignition of the China/U.S. trade row sent raw materials prices back down after a slight uptick over the past couple of weeks. The story here remains that building and manufacturing demand is tepid and the drop in lumber prices suggests underlying economic weakness. The story of the past week has been trade but lumber prices are reinforcing the notion that investors should be cautious.

Conclusion? It’s been all about trade over the past week. The unexpected turn of events resulted in investors removing risk from their portfolios and fleeing to safe havens such as utilities and Treasuries. The overarching sentiment remains decidedly defensive and investors will likely wait for fresh signs of optimism before returning to riskier assets. Continued weakness in materials prices could be a signal that further downside is still ahead, and increasing the odds of a Spring Crash in the S&P 500 (SPY).

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.

Additional disclosure: This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. It also does not offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.