Earlier in my MorningWord (Seeing the Forest For the Trees) I tried to explain why the relative out-performance in defensive stocks and sectors like U.S. telco, utilities, consumer staples and sectors like energy and materials (that got slayed in 2015) is a bullish rotation:
A couple of my co-panelists disagreed with my view and said that we are in a market of stocks and that there are plenty of stocks and sectors working in 2016 and the broad market was going “sideways”. My response is simple, the broad market is in a downtrend, not a consolidation, and what’s working in 2016 is either really 1) defensive sectors like U.S. consumer staples, telcos, utilities, or 2) a dash for trash in some energy, material, retail and industrial stocks that got murdered in 2015. That is not bullish. And the reaction of a stock like Walmart (WMT) yesterday (to their full year guide down), and Deere (DE) this morning (on weak results), means we could be seeing and unwind of that second leg of “what’s working”. Both WMT and DE got murdered last year, and were showing relative strength in 2016.
A rotation out of banks and large cap tech into energy, materials and industrial based on NO evident improvement in company fundamentals or an uptick any global economic activity is merely bottom picking, not signs of a bullish turn by investors.
I fully recognize that a bounce in global equities was due given what was a deep pessimism towards stocks while investors were also reaching for risk off trades like U.S. Treasuries and Gold. But as I noted in my earlier post, the rally seems exhausted and the lack of fundamental change in the last week on the macro and micro leads me to believe that a retest of the prior lows will be in the offing. To illustrate the precarious technical footing MOST U.S. stocks are on holistically, I used the equal weight Value Line Arithmetic index, and equal weighted index encompassing about 1700 U.S. stocks:
Here is the 2 year showing yesterday’s rejection at a prior support level:
And then the 8 year chart, showing the late 2015 breakdown below the uptrend that has been in place since the lows of the financial crisis:
It’s my view that the ingredients that made buying every dip on the way up attractive, no longer exist. The path of least resistance is no longer higher, and the uncertainty around U.S. central bank policy, with the backdrop of a fragile global economy, means a material correction is more likely to occur in 2016, as opposed to a move back towards the prior all time highs made in the Spring of 2015.
In the near term I suspect we see a investor move out of the 2016 out-performance trades in sectors like basic materials as it appears to me that without any real fundamental improvement that the recent rip was nothing more than a short squeeze.
The XLB, the Materials Select etf is made up of a lot of chemical companies like Dow Chemical (DOW), Dupont (DD), Monsanto (MON), Lyondell (LYB), Praxair (PX) and Air Products (APD) which combined make up about 50% of the weight of the etf. These stocks got nailed in 2015 given their massive exposure to the strength of dollar, which ironically was offsetting the benefit of lower oil costs, which is a massive input to most of these companies. Lastly there are also mining and metals stocks like Alcoa (AA), Newmont (NEM), Nuecor (NUE) and Freeport (FCX), all of which have had massive gains of late from recent lows.
It’s my view that if the broad market moves lower, we will see correlations go back towards one, and these stocks could see a sharp move lower as those who had a good trade look to lock in profits, and shorts take another crack.
So what’s the trade?
*XLB ($40.75) Buy March 40 Put for 90 cents
Break-Even on March Expiration:
Profits: below $39.10
Losses: up to .90 cents between $39.10 and $40, max loss of 90 cents, or 2.2% of the etf price.
Rationale: The XLB has been in a massive downtrend in the last year, making a series of lower highs and lower lows, the etfs’s 12% rally from the Jan lows makes for a good defined risk short entry.