Equity Rundown: Stay Long Financials and Maintain Defensive Positions

Summary

• Our model equity portfolio is down 2.9% since inception, largely due to poor performance of financials following the Silicon Valley Bank collapse.
• We are bearish on equities because we think inflation will prove sticky and the Fed will not deliver the rate cut markets are pricing.
• Our portfolio is generally positioned defensively. We maintain long positions in financials on expectations that the recent selloff was overdone.
• We are unwinding our short position in Homebuilders given the strong earnings homebuilders have posted recently.

Performance Overview: Financials Dig a Deep Hole

Our model portfolio is down 2.94% since inception, primarily due to the sharp drop in regional bank equities following the Silicon Valley Bank (SVB) collapse on 10 March. Since our last update on 24 February, our financial sector trades have flipped from +6.8% to ‑7.0% (see Appendix for full trade summary).

Our clean energy ETF trades also continue to underperform, going from down 14.1% to down 16.4%.

Core View: Headwinds Leave Us Defensive

The S&P 500 (SPX) has traded in a range around 4000 since May 2022. During that period, the Fed has raised rates from 0.75% to 4.75% (lower bound). Earnings have basically flatlined. Equities have avoided a further selloff on hopes the Fed will soon stop raising rates and possibly cut them. Continued strength in the labour market and economy has fuelled hopes the Fed can subdue inflation and engineer a soft landing.

Despite the aggressive pace of hikes, we think the Fed is still dovish. To the extent that it appears to endorse ending rate hikes when the Fed Funds rate reaches 5.00-5.25%, the Fed is indeed dovish. Whenever the economy has heated up and inflation has risen in the post-war period, the Fed has had to raise rates at least 2 percentage points above inflation to control things. That implies rates must hit 7.5% or higher unless inflation somehow drops sharply.

Accordingly, if the Fed halts rates around 5%, inflation may have to drop to 3% or lower before it has a case for cutting rates.

We believe inflation will prove sticky unless the Fed takes tougher steps than it seems to be contemplating. It may blink and cut rates well before inflation reaches 3% – as it has at almost every juncture when markets threw a fit since the stock market crash of 1987. If it does cut, equities will surely rally. And if inflation rallies too, equities will likely then selloff significantly as investors appreciate what the Fed must do next.

In coming weeks and months, we expect the cumulative weight of higher rates to slow the economy and weaken earnings. Perhaps the Fed will convince markets that a rate cut is not in the works until inflation drops significantly. These developments should push equities to the lower end of the trading range since last May.

We do not expect equities to collapse unless something happens to cause a more severe recession.

Given these views and outlook, we are generally positioned defensively.

New Trades

Unwind XHB Short – We unwind our short position in homebuilders (XHB) versus long SPY. We initiated this trade on 28 May 2021. It is up 7.3% since inception. It has been up more than 20% at times. Homebuilders have underperformed due to overwhelming negative sentiment toward the sector. XHB has rallied recently on solid earnings from homebuilders. We often argued homebuilders today are focused on building to order and profitability, not building on spec in the hopes that buyers show up. Homebuilders could rally further if the market remains in the current trading range but will be vulnerable in a selloff. We may reinitiate this trade if or when the market moves to the downside.

Existing Trades

Long KBHB – The KBHB ETF covers the banking sector, including major and regional banks. We had been short KBHB on expectations it would underperform regionals. Following the SVB collapse, this position outperformed massively. We unwound this trade on 27 March when it was up 45%, and implemented the reverse trade – long KBWB/short SPY.

Long Major Banks – We also initiated long positions in several major banks, including Bank of America (BAC), Citigroup (C), Goldman Sachs (GS), JPMorgan Chase (JPM), and Morgan Stanley (MS). We think these major institutions are largely insulated from the risks facing regional and community banks and that the selloff in these equities was overdone.

Short Semiconductors – On 19 April, we initiated a short position in the semiconductor sector via the ETF SOXQ, which tracks the Philadelphia Semiconductor Index. SOXQ has rallied in 2023 even as forward earnings have dropped 16%. Tech-related CAPEX was a key factor driving semiconductor demand in 2022, but we expect CAPEX growth will roughly align with inflation in 2023. We expect SOXQ will underperform the SPY and NASDAQ 100 (QQQ ETF) in any broad market selloff.

Sector Views and Update

SPX Sectors

Communications (XLC) – Our short position in XLC has underperformed by 3.1%, largely due to the rally in tech stocks. Google comprises about 30% of the index, Meta about 12%. These stocks are up 18.4% and 27.3%, respectively, since our last update. Both have benefited from the tech rally broadly and newfound commitments to controlling costs. But both also depend on advertising revenue to top-line growth, and we see no indication that advertising is recovering. We maintain this position for now.

Consumer Discretionary (XLY) – Our short position in XLY is up 14%. XLY is a mix of goods-oriented companies that are faring well and service companies that are doing well as consumers shift spending away from goods. If, as we expect, the economy slows in coming months, XLY should come under more pressure.

Consumer Staples (XLP) – XLP has lost ground recently as equities have rallied but should recover in any significant equity selloff.

Energy (XLE) – Long XLE is our favourite trade. Energy companies continue to emphasize returning cash to investors over ramping up exploration and production. Returns will come via higher dividends and share buybacks.

Financials (XLF) – The broad financial sector went from up 6.4% as of our previous update to down 4% following the SIVB collapse. We expect the banks included in this index to gradually recover so maintain this position.

We maintain positions in other SPX sectors for now.

Clean Energy

Our clean energy ETFs are down 16.4% since inception. The only one that is up is GRID, which mostly holds traditional utilities that have made significant investments in smart grid technology.

Most of the other ETFs focus on companies investing in various parts of the clean energy supply chain, including minerals, batteries, wind and solar technology. Many of these are startups or smaller companies, and today’s market is hostile toward companies in loss-making mode.

However important it may be for society to migrate from fossil fuels to clean energy, there is little or no money to be made here – at least not within a normal investor’s timeframe. That may be one reason why society is moving so slowly to make the transition – or perhaps society is not ready to pay the full price of moving to clean energy.

We maintain these positions if only to monitor what is happening with the business side of clean energy. We see little reason to add to positions currently.

Financials

We maintain long positions in KIE (insurance) and KRE (regional banks). KRE will not recover to its previous level, but we think the selloff is overdone and that it will partially recover in coming months.

More information about how we structure and measure trade performance is available at https://macrohive.com/hive-exclusives/how-we-structure-equity-trades-and-measure-performance/ 

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)