Equity Rundown: Steady in the Storm

Portfolio Summary

• Performance: Our ETF model portfolio is up 0.4% since inception and down 1.5% over the past month. Energy was the worst performer, primarily because of a 16% drop in oil prices.
• Changes: We unwind short positions in three European equity indices – Euro Stoxx 600 (SXXP), Euro Stoxx 50 (SX5E), and the FTSE 100 (UKX).
• Updates: The most attractive sectors are healthcare and energy. Both are significantly undervalued vs earnings outlooks. The consumer discretionary sector is still overvalued and the least attractive sector. We still favour value over growth.

Outlook and Asset Allocations

• We see risks for equities tilted to the downside in 2023 due to economic weakness and soft earnings.
• We still recommend an underweight in equities relative to other asset classes.

Portfolio Performance

Our model exchange-traded fund (ETF) equity portfolio trades are now up 0.4% overall since inception and down 1.5% over the past month. Excluding the underperforming clean energy sector, we are up 4.0% and down 1.7%, respectively (Appendix).[1]

This sideways performance is unsurprising given that the S&P 500 (SPX) has traded in a well-defined range for the past six months after a systemic selloff in H1 2022, when the 10-year Treasury yield jumped from 1.5% to 3.5%.

Most sectors and trades were little changed over the past month. The one notable underperformer was the energy sector, with a -13.7% return as West Texas Intermediate (WTI) oil dropped from $87/bbl to $73/bbl, although it remains our best-performing trade. We remain bullish on the energy sector, given energy company commitments to return capital to investors rather than invest in new exploration and production.

Portfolio Changes

The one change since our last monthly update was to unwind short positions in three European equity indices – Euro Stoxx 600 (SXXP), Euro Stoxx 50 (SX5E), and the FTSE 100 (UKX) – as the economic outlook has improved since last summer.

We are maintaining our current positions going into year-end, although we may make one or two changes after this week’s Consumer Price Index (CPI) print and Fed meeting.

Portfolio Updates

Major Indices

We are short the NASDAQ 100 (NDX) and Russell 2000 (RTY). We anticipate the economy and earnings will weaken in 2023, keeping pressure on these higher beta indices.

According to our model, both indices are overvalued by more than 10%, while SPX trades close to fair value. We acknowledge the NDX and RTY will certainly outperform SPX when the market starts a sustained rally recovery; they are overvalued because investors still think (hope) a Fed put will come into play when a recession happens or unemployment rises.

SPX Sectors

Communications (XLC) – We are long XLC because our valuation models suggest that it is very cheap relative to trailing and projected earnings. This trade has not gone our way and is down 14.6% since inception, although it is up 3.1% over the past month. We expect this sector to perform roughly in line with the broader market for now and outperform when a recovery takes hold.

Consumer Discretionary (XLY) – Our short position in XLY has outperformed by 15.1% since inception. We are maintaining this position because XLY is more than 30% overvalued relative to earnings. Further, projected earnings have fallen 15% over the past six months. We see further downside for XLY on any further market or economic weakness.

Consumer Staples (XLP) – Conventional wisdom calls for being long consumer staples in a declining market, but we maintain a short position because XLP is about 10% overvalued according to our valuation model. This trade has underperformed by 7.1% since inception. XLP has traded rich because margins rose during the pandemic. They are returning to normal levels now. Still unknown is whether consumer staples companies can keep passing on rising costs to consumers or if they take hits to margins.

Energy (XLE) – Energy is our favourite and best-performing sector. As mentioned, it has traded off in recent weeks due to soft energy prices. If China reopens in 2023, energy prices should recover. Nevertheless, the key for the energy sector returns is not oil and gas prices anymore but total returns from dividends and stock buybacks. Most energy companies have announced plans to focus on returning capital to investors rather than investing in new exploration and production ventures. For example, ExxonMobil (XOM) recently increased its buyback program from $30bn to $50bn.

Financials (XLF) – We maintain our long position in financials as it should benefit from the Fed’s ongoing rate hikes.

Healthcare (XLV) – XLV appears very cheap relative to projected earnings. Even in a recession, we do not expect this sector to take a significant hit to earnings.

Industrials (XLI) – Industrials have performed well so far. But as recession risks rise, we will re-evaluate this long position.

Materials (XLB) – If China reopens during 2023, we expect rising demand for raw materials. We are maintaining this position unless the outlook for China reopening changes.

Real Estate (XLRE) – This sector has been hit hard by rising rates, though we think most of the bad news is already priced in. We expect XLRE to perform roughly in line with the broader market, then outperform in the recovery scenario.

Technology (XLK) – The SPX tech sector has outperformed because it is a combination of consumer and enterprise-facing companies. The latter has experienced strong demand from corporate clients upgrading their technology platforms. If the economy weakens in 2023, this source of demand should also soften. We maintain this short position.

Utilities (XLU) – We maintain a long position in XLU because that is the conventional wisdom trade in a down market. However, XLU is rich relative to earnings, and utilities as a sector has been steadily increasing leverage to maintain a high dividend payout. We may reverse this position in the near future.

Sector Updates

Clean Energy

Our clean energy ETFs are down 10.3% since inception. Despite talk of moving away from fossil fuels to clean energy, most governments around the world have yet to set in place policies and commit the resources to make this happen – a point that was abundantly clear at the recent COP27 meetings. We have said before this is a patient trade. For now, we expect clean energy to perform roughly in line with the broader market. We maintain our long positions but would not add to them at this time.

Growth vs Value

We maintain our long position in value (RPV) and short position in growth (RPG). In a market where rates rise further and risks tilt to the downside, we expect growth companies to struggle more than value companies.

Homebuilders

We maintain a short position in homebuilders (XHB), given the weak housing market. This is not a high-conviction trade. We think homebuilders can still be profitable, albeit at more modest levels than before 2022. The key reasons are the overall shortage of housing in the US and that homebuilders did not go into this downturn with large inventories of speculative housing like in 2008. We expect XHB to perform roughly in line or slightly worse than the broader market.

Travel/Leisure (AKA the Reopening Trade)

We maintain a long position in travel/leisure ETF PEJ and airline ETF JETS, largely because demand for travel remains strong. Airlines, in particular, should benefit from limited capacity and strong pricing powers. So far, consumer appetite for travel has been robust and shows little sign of dimming, but we will continue to re-evaluate as recession risks rise.

Appendix

[1] A description of our portfolio methodology is available here.

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.

(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.)