XLE And Our Market Outlook

Summary

• The yield spread between the Energy Select Sector SPDR ETF (XLE) and risk-free rates is at a very attractive level currently.
• The conflict in Ukraine provides a near-term catalyst to XLE (and other energy sector funds too).
• You will also see, from our market sector dashboard, that XLE is also attractive compared with other sectors.
• The dashboardgives us a 30,000 feet view of the market conditions and where to look further.
• Next to the energysector, small-caps are also at an attractive level.
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Thesis and Background

We use the following market sector dashboard to put our finger on the pulse of the market and its major sectors. Especially, the simple yield spread (the TTM dividend yield minus the 10-year Treasury rates) is the first thing we look at. They give us a 30,000 feet view of where to look further - which sector, growth stocks, value stocks, bonds, or precious metals, et al. We will detail the meaning of each entry in the next section, and we update the dashboard monthly. Feel free to download or export the google-sheet via the following link too: Market Sector Dashboard.

A few overall impressions on the market and the Energy Select Sector SPDR ETF (NYSEARCA:XLE) this month:

• XLE currently is supported both by strong technical signals and also fundamentals. On the technical side, its price has rated for more than 22% in the past quarter while the overall market went nowhere. On the fundamental side, both its dividend yield and the yield spread relative to the risk-free rates are at a very attractive level. The conflict in Ukraine provides a near-term catalyst to XLE.
• The dashboard also shows that XLE is also attractively valued compared with other sectors. And next to the energy sector, small-caps are also at an attractive level currently, followed by the health sector.
• Surprisingly, the overall market (represented by a simple average of the sectors in the dashboard) features a slightly positive yield spread relative to the Treasury risk (Z-score about 0.3%). For us, this signals that equity, especially high-quality stocks with a reasonable valuation, are more favorable than bonds.

With the above overall discussion, we now move on to the specifics of the dashboard and XLE.

Source: author

The dashboard explained

Hope most of the entries in the dashboard are self-explanatory. And here I just point out a few specifics.

• The yield spread Z-score. It gauges the dividend yield of a given sector relative to the 10-year Treasury rates. How the yield spread is calculated will be detailed in the next section. A larger Z-score suggests larger undervaluation compared to the historical record and Treasury rates. And vice versa.
• A Z-score that is closer to 1 means the yield spread is near the thickest level of the historical spectrum and is color-coded by bright green. And vice versa.
• The yield spread Z-score. Similar to the yield spread Z-score, it gauges the dividend yield of a given sector relative to its own historical record. A larger Z-score (greener) suggests a larger undervaluation compared to its own historical record. And vice versa.

Yield spread and yield spread Z-score

For bond-like equities fund XLE, an effective way to evaluate their valuation with interest rates adjusted is to calculate the yield spread. Details of the calculation and application of the yield spread have been provided in our earlier article. The yield spread is an indicator we first check before we make investment decisions. We've fortunately had very good success with this indicator because of:

• Its simplicity - it only relies on the most simple and reliable data points (Treasury rates and dividends). In investing, we always prefer a simpler method that relies on fewer and unambiguous data points rather than a more complicated method that depends on more ambiguous data points.
• Its timeless intuition - no matter how times change, the risk-free rate serves as the gravity on all asset valuations and consequently, the spread ALWAYS provides a measurement of the risk premium investors are paying relative to risk-free rates. A large spread provides a higher margin of safety and vice versa.

With this background, you will see below that when adjusted for interest rates, XLE's current valuation is at an attractive level.

The following chart shows the yield spread between XLE and the 10-year Treasury. The dividend yield is calculated based on the TTM dividends. As can be seen, the spread is bounded and tractable most of the time. The spread has been in the range between about 1.5% and 0% the majority of the time during the past decade between -1% and 1.6%. Suggesting that when the spread is near or above 1.6%, XLE is significantly undervalued relative to the 10-year Treasury bond (i.e., I would sell Treasury bond and buy XLE). In another word, sellers of XLE are willing to sell it (essentially an equity bond) to me at a yield of 1.6% above the risk-free yield. So it is a good bargain for me. And vice versa.

You can see the screaming signal in 2020 when the yield spread surged to the ~9% level - and this is why this dashboard is the first thing we look at when we make our investment decisions.

As of this writing, the spread is about 1.32% as you can see. It is still a level that is toward the wider end of the historical spectrum and is above the historical average by a comfortable margin. Such a wide yield spread still provides a healthy cushion for investors in the near future, especially against interest rate uncertainties.

Author based on Seeking Alpha data

For readers familiar with our analyses, you know that the short-term returns are closely correlated with the yield spread for many of the funds and stocks. However, in the case of XLE, the correlation is not as strong as you can see from the following chart. And the major reason is the wide fluctuation of commodity prices. This chart shows the two-year total return on XLE (including price appreciation and dividend) when the purchase was made under different yield spread. There is a positive trend, indicating that the odds and amount of the total return increase as the yield spread increases. But the correlation coefficient is only about 0.49, a mildly strong correlation.

Again, the screaming buying opportunities in 2020 are highlighted in the orange box. And you see the outsized return in the next 2 years. As of this writing, the yield spread is 1.32%, close to the wider end of the historical spectrum, suggesting manageable valuation risks in the near future.

Author based on Seeking Alpha data

Conclusions and final thoughts

We use a Market Sector Dashboard to put a finger on the pulse of the market and its major sectors. For this month, our key observations are:

• XLE currently is supported both by strong technical signals and also fundamentals. On the technical side, its price has rated for more than 22% in the past quarter while the overall market went nowhere. On the fundamental side, both its dividend yield and the yield spread relative to the risk-free rates are at a very attractive level. The conflict in Ukraine provides a near-term catalyst to XLE.
• Although, in the case of XLE, the correlation between the yield spread and its short-term price appreciation is not as strong as other funds and stocks we've analyzed due to the wide fluctuation of commodity prices.
• The above dashboard and conclusions apply to other energy funds too, such as the Vanguard Energy Index Fund ETF Shares (VDE) because these funds are very similar and highly correlated.
• Other than XLE, small-caps are also attractively valued too, followed by the health sector.

Thx for reading and look forward to your comments!

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.