Equity Rundown: Maintain Defensive Positions

Summary

• Our model ETF portfolio is down 1.6% since inception and 2.4% over the past month.
• Given our bearish outlook for 2023, our portfolio is skewed toward defensive positions, which have underperformed as investors increasingly discounted the recession scenario in 2023, and the S&P 500 rallied 4.2%.
• We remain bearish on the economic outlook while the Fed is raising rates.
• Considering this view, we reverse our long Communications sector and short Consumer Staples sector trades. We are now short Communications and long Consumer Staples versus opposite positions in the S&P 500.

Introduction

Our ETF model portfolio is down 1.58% since inception (Table 3). Ex the underperforming clean energy sector where we are long, the portfolio is up 2.54% (methodology here).

Given our bearish outlook on the US economy and equities, our portfolio is tilted toward defensive positions. They have generally underperformed since 2023 began as the S&P 500 (SPX) and NASDAQ 100 (NDX) rallied 4.2% and 10.2%, respectively.

We have made two changes to the portfolio since our last update a month ago. On 27 January 2023, we switched our long positions in SPX industrials (XLI) and materials (XLB) versus a short in SPX (SPY), to short Industrials and Materials versus long SPY. Those positions are down 0.1% and up 2.7%, respectively.

We make two more changes:

• Reverse long SPX (SPY)/short Consumer Staples (XLP) to long XLP/short SPY.
• Reverse long Communications (XLC)/short SPY to long SPY/short XLC.

Read on for our rationale.

Portfolio Updates

SPX Sectors

Communications (XLC) – Our long position in XLC is down 7.5% since inception, but up 8.4% since the beginning of the year. This sector is a combination of high-tech companies like Alphabet (GOOG), Meta Platforms (META) and Netflix (NFLX) and old-line telecoms like Verizon (VZ) and AT&T (T), with some newspapers and media companies thrown in. We have been long XLC because by our metrics XLC appears undervalued.

With the recent rally the valuation gap closed – until analysts boosted year ahead forecast earnings by an improbable 17% over 12-month trailing earnings, making XLC appear cheap again. Our review of 4Q earnings gives little indication that the source of strong earnings – digital advertising – is unlikely to recover within the next few quarters. That is implicitly corroborated by layoffs sweeping through the tech sector. In addition, big tech companies face growing regulatory headwinds. We are unwinding this trade and replacing it with a long SPY/short XLC position.

Consumer Discretionary (XLY) – Our short position in XLY is up 11.2% since inception, but down 8% year-to-date. This is a heterogeneous sector, including recreation-oriented subsectors (such as cruise companies and casinos), which have rallied strongly, as well as retailers that are bearing the brunt of the consumer shift from goods to services. The ‘fun’ names and positive sentiment about the H2 outlook has supported XLY recently. We see this support eventually fading and maintain our short position.

Consumer Staples (XLP) – Our short position in XLP is down 3.7% since inception, but up 6% since the beginning of the year. Even though we anticipated a slowing economy in April 2022, we initiated this contrarian position because XLP appeared 10%-15% overvalued based on our valuation metrics.

This trade has not worked out as expected. As recession concerns rose in Q4 2022, XLP performed like a defensive stock, outperforming SPY. At one point the trade was down as much as 10%. The more recent outperformance was because, as investors became more bullish about the economic outlook, SPY outperformed defensive sectors.

There are good fundamental reasons to maintain this short. XLP continues to be modestly overvalued versus SPY. Several retailers and major food companies, including PepsiCo (PEP), Coca-Cola (KO) and Kraft Heinz (KHC), have said they plan to limit price increases in 2023. Clearly, after price hikes in 2022, price/volume elasticities are now working against them. XLP earnings will be under pressure.

Balanced against that is market conventional wisdom – if the economy slows as the Fed keeps raising rates, investors will move into traditional defensive sectors regardless of valuations. We bow to convention and reverse this short XLP position to long XLP/short SPY.

Energy (XLE) – Our long XLE long position is up 16.7% since inception, but down 8.3% since the beginning of the year. This is primarily due to oil prices falling from near $90 in Q4 2022 to $75 recently. This is no surprise – energy equities tend to track oil prices. We see some prospect that oil prices could rise to the $100-120 range later this year, which would spark a recovery in energy stocks.

That aside, the primary reason for our long position is that many oil and gas companies have turned from investing profits on exploration and production to a policy of returning capital to investors via dividends and share buybacks. Total returns over the medium-term will depend less on share price performance. We view this as a long-term hold and see the current dip as a particularly attractive opportunity to enter or add to the trade.

Financials (XLF) – XLF is up 6.1% since inception and is little changed year-to-date. Financials will benefit from a tailwind while the Fed raises rates and deposit rates rise more slowly. We maintain this position.

Healthcare (XLV) – XLV is up 3.7% since inception, but down 8.2% year-to-date for the same reason as consumer staples – defensive stocks have been less attractive so far in 2023, as investors anticipated a soft landing and a rate cut. We are more bearish on the economy and maintain this long position.

Industrials (XLI) – This short XLI position is little changed since inception. We expect the broad industrials sector to perform roughly in line with, or modestly worse than, SPY, as the Fed continues to raise rates.

Materials (XLB) – This short XLB position is up 2.7% since inception. This sector provides a wide variety of inputs to the industrial sector, including chemicals, construction materials, and various metals. The China reopening may provide some support for this sector, but it will underperform if industrials weaken.

Real Estate (XLRE) – Our long position in XLRE is down 12.7% since inception and little changed year-to-date. We had expected this sector to withstand higher rates, due to the opportunity in recent years to refinance debt at low rates and the shortage of residential housing in the US. Clearly, XLRE has been hurt by weakness in the commercial property sector (due to people working from home) and by conventional wisdom about real estate as rates rise.

From a valuation standpoint, XLRE appears attractive. We will soon review the composition of this ETF to better understand systemic and company specific risks.

Technology (XLK) – Our short XLK position is down 0.9% since inception, and down 4.8% year-to-date. XLK has benefited from the more bullish sentiment so far in 2023. We are more bearish on the economic outlook and maintain this short position.

Utilities (XLU) – XLU is perhaps the ultimate defensive sector. Our long position is down 2.1% since inception, and 8.8% since the beginning of 2023. If we are correct about the economic outlook, we expect this trade to recover in coming months.

Clean Energy

Our long clean energy trades are down 14% since inception and down 4.2% over the past month. Given the flow of money entering the sector, due to the Inflation Reduction Act and growing demand for electric vehicles, this ongoing underperformance of clean energy EFs seems to make little sense. We will analyse the composition of these ETFs soon to better understand the source of underperformance. Pending that review, we maintain these long positions.

Homebuilders

Our short homebuilder (XHB) position is up 7% since inception and down 5.7% year-to-date. XHB benefited from the more bullish outlook in 2023 and because homebuilders have proved adept at managing their businesses despite higher rates and slower demand. Unlike previous rate cycles, homebuilders did not go into this one with inflated inventories.

We expect homebuilders will continue to perform better than expected – but this will not be enough to overcome the conventional market wisdom that homebuilders underperform badly in rising rate environments.

Reopening Trades

Our long airline (JETS) position is down 1.6% and travel/leisure (PEJ) is down 7.2%. Both are up about 8% year-to-date. Given the apparent consumer demand for travel and experiences and robust outlooks from casino, hotel, and recreational companies, we maintain these long positions.

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.)