In this article, I will be detailing how I am preparing for what is likely to be a volatile fall given there are the election, seasonality, and overbought conditions. In my opinion, the market has been focused on everything COVID-19 and rightly so; however, as the election nears, I expect the market to shift focus to the election. Therefore, now is the time to prepare before the market shifts its focus to the election and to get ahead of a seasonally weak time.
Usually, the market is choppy in an election year, so this year that has been true again, but not due to the prospects of the election, instead because of COVID-19. As we inch closer to the election, I expect the election will get more into the news cycle and garner more attention in the markets since right now the market is focused on everything COVID-19. Given everything that has gone on and what I see, the two most likely outcomes are democrats have a clean sweep, winning the presidency, senate & house, and the other scenario is Biden wins, but the senate stays narrowly in republican control. From a purely economic point of view, I believe Trump winning and the senate remaining republican is the best outcome for the market. I do not know if that is in the cards given everything that has gone on, so at a minimum, I am preparing for a Biden victory.
One way to measure the odds of a democratic sweep is to look at PredictIt. As of the writing of this article, a clean sweep in November is trading at $0.56, so it is essentially saying the odds of a clean sweep are 56%. If that data is pointing towards that possible scenario, I want to be prepared. After I go over the seasonality and overbought sections, I will show some possible options that could help minimize risk during times of market stress.
There is a lot of research on seasonality in the market, so I am not going to spend a lot of time on it. The chart below is a couple years old, but it illustrates the point that August-October is usually a seasonally weak period and in anticipation of that, I believe it will be best not to chase stocks. I believe a correction will occur leading up to the election but not just because of the historical seasonality, there is the added dimension of overbought conditions to consider as well.
Large technology and communications stocks have been driving the market and are now at overbought conditions. The NYSE FANG+ Index consists of the following group of companies that are widely held among investors. The second chart is what is important in this section because it shows this group of companies overbought. The data shows this group of companies has a MACD that is the highest in its history since the index data was available in late 2017. More troubling is there is a negative divergence that is occurring because the RSI is at elevated levels but has failed to reach the RSI level the index was in February of this year even as the index has been making new highs. With the MACD at its highest level and the RSI diverging, from a technical perspective, this is pointing to a coming correction in this group of stocks. If there is a correction with this group of stocks, it can have an impact on the market because of the weights they have in the S&P 500 (SPY).
Source: NYSE FANG+ Index
*Chart scale is weekly
In this section, I am going to go over a number of ideas for how to prepare for the above conditions. I will go over some general areas like quality vs. value, alternative energy, and covering some industries that might be worth looking at using a barbell approach. The two industries covered in my barbell approach are the garbage industry and the digital infrastructure industry.
Quality over Value
In this section, I am going to go over a number of strategies and ideas for how to prepare for the above conditions. In a volatile environment and during the majority of market conditions, when searching for individual companies and ETFs, I find it best to focus on quality companies and ETFs and not to chase yield or value. I focus on companies whose underlying businesses will be fine because their underlying businesses have secular tailwinds, are essential or have a distinct competitive advantage. One of the few hits to those types of businesses might be from higher taxes in a democratic administration. Conversely, I find it best to avoid companies whose underlying businesses could be seriously impacted by a democratic administration, like those in the energy sector.
For example, the following chart shows a comparison of the Invesco S&P 500 Quality ETF (SPHQ) and the Vanguard S&P 500 Value ETF (VOOV), which has been the best performing large-cap value ETF over the last five years. As you can see, quality has consistently outperformed value over the last five years and done so with slightly less volatility.
In my own portfolio, one of the companies I own is Waste Connections (WCN) because it is one of the big three in the trash collection industry with the other two major companies being Waste Management (WM) and Republic Services (RSG). The trash industry is a necessity and is recession-resistant in my opinion, which can be a good place to hide out during times of uncertainty. The following chart shows the performance of the three waste companies compared to the S&P 500 (SPY) and the Industrial Sector SPDR (XLI) for the time frame starting on February 19 (previous market top) going until March 23 (market bottom). As you can see, shares were all down around 30%, which was slightly better than the S&P 500 and significantly better than the industrial sector. So, you might be thinking, what is the point of owning something that could go down that much during the crash. The key is the length of time you plan on holding. If you are holding for the long term, getting opportunities to add to companies that are necessities is appealing in my book.
Source: Yahoo Finance
I am a big believer in digital infrastructure being a place to hide out during market corrections and feel fine even if their stock price may be falling. The types of companies I am talking about are technology focused, like cell and data center REITs. These stocks as represented by the Pacer Data & Infrastructure Real Estate ETF (SRVR), sold off during March with the rest of the market but fell less than the S&P 500 or the Vanguard Real Estate ETF (VNQ). Data center REIT Equinix (EQIX) and cell tower REITs American Tower (AMT) and Crown Castle (CCI) make up 43% of the fund. In a world where rent collections have an increased importance for REITs, owning these technology REITs is appealing. For example, I have very little worry about Verizon (VZ), AT&T (T) or T-Mobile (TMUS) not paying their rent to American Tower or Crown Castle. Because of that, during the crash in March, I added to my existing position in SRVR and was able to pick up these high-quality companies at a discount to where they had been.
Source: Yahoo Finance
Alternative Energy ETFs
As noted above, there is a real possibility of a Democratic sweep in November and if that were to occur, I see two ways to invest to benefit from that scenario. The two routes that could be profitable in that situation are to bet against a sector like energy or to focus on alternative energy ETFs. Shorting energy could be a good idea if there is a democratic sweep because of the perceived increased amount of regulations on the sector. I do not short stocks and there is not a non-leveraged ETF that shorts the energy sector that has viable assets. Therefore, that leaves alternative energy ETFs as the better way to invest in a democratic sweep scenario.
For alternative energy ETFs, after doing some research, the top choices that I will be considering adding prior to the election are either the Invesco WilderHill Clean Energy Portfolio ETF (PBW) or the ALPS Clean Energy ETF (ACES). To narrow it down to those two funds, I started my search by looking at available clean energy ETFs that had over $100 million in assets. Some of the key items I was looking for were how the funds performed, domestic vs. international exposure and the weighting of the holdings within each fund.
Year to date, PBW is up 43% and ACES is up 38%, which only trails the First Trust NASDAQ Clean Edge Green Energy Index ETF (QCLN), which is up nearly 45%. PBW is appealing because the fund has performed well, has over 80% exposure to North America, and is equally weighted. I am not looking for a fund that is heavily weighted with a large Tesla (TSLA) position like QCLN, which has a 10.46% weighting to Tesla. ACES is appealing because the fund has performed well, has over 98% exposure to North America, and is market-cap weighted, but caps individual holding weight at 5%. For example, right now Tesla has a 7.28% weight in the fund, which is higher than I like, however, on the rebalance date, the fund will lower its Tesla stake to get below the 5% allocation threshold, essentially buying low and selling high.
Because of the historical seasonality and the overbought conditions that are present, one way to mitigate risk during a correction is to consider alternative ETFs. Two examples of types of funds that help mitigate losses during a correction are the First Trust Long/Short Equity ETF (FTLS) and the IQ ARB Merger Arbitrage ETF (MNA). FTLS has a long portfolio and a short portfolio that currently works out to the fund having net long exposure of 70%. According to the FTLS fact sheet, the ETF usually maintains a long portfolio percentage of between 80% and 100% and the short portfolio can range from 0-50%. In the event of a market correction, having short exposure to mitigate losses is an appealing aspect to consider.
MNA is a merger arbitrage fund that has a unique hedge in comparison to other merger arbitrage funds. In a normal merger arbitrage fund, it would go long the companies being acquired and short those companies who are doing the acquiring. MNA, on the other hand, is different because it holds a long position in companies being acquired and instead of shorting the acquiring companies; MNA holds a portfolio of short positions in broad market ETFs.
Both of these ETFs will help mitigate losses during a correction but still be OK to own during times when the market is going up. The following chart shows the performance of FTLS and MNA compared to the SPY from the highs in February until the lows in March.
Source: Yahoo Finance
One important aspect of all these ideas is having cash available to take advantage of opportunities that present themselves. Personally, an example of how this worked out for me was during the crash I was able to add high-quality companies at a discount. During the crash, I initiated new positions in Microsoft, Merck (MRK), and Martin Marietta Materials (MLM). The only reason I was able to do that was I had cash available. As of right now, I am holding the highest allocation to cash since I started investing in 2008 because I see a lot of uncertainty coming this fall. I do plan to deploy some of the available cash into a Green/Alternative Energy ETF because of the growing importance in those areas and I am also planning on buying an ETF to hedge against a market decline. Green/Alternative Energy ETFs are an area that would stand to benefit significantly in a Biden administration and would likely see very large gains if there is a democratic sweep in November.
In closing, I believe now is the time to prepare for a coming correction this fall brought on by seasonality, overbought conditions and the election. Right now, the market is focused on everything COVID-19, and once the election gets closer, I believe the market is going to shift its focus to that. The best way I believe to prepare for this is to focus on quality companies, companies in industries that are necessities like garbage and digital infrastructure, alternative energy because of possible election results, hedge and to hold/raise cash.
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Disclosure: I am/we are long SRVR, WCN. 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.