Equity Rundown: Positioning for a Soft H1 2023

Summary

• Our long/short ETF model portfolio is up a modest 2% since inception, and 11% excluding the difficult clean energy sector. Clean energy ETFs hold some Chinese companies, which could recover if the reopening takes hold.

Outlook and Asset Allocation

• We are neutral for now on equities in our overall asset allocation framework but see risks tilted to the downside. We think equities will struggle while the Fed is raising rates and fighting inflation.
• We favour overweighting the S&P 500 (SPX) versus underweighting the NASDAQ 100 and Russell 2000.
• Our favourite SPX sectors are energy and healthcare. We are negative on consumer discretionary and technology sectors. We also like the airline (JETS) and insurance (KIE) sectors.

Introduction

Our ETF model portfolio is up a cumulative 2% since inception and 1% over the past month. This flat performance is unsurprising given that equities have been range bound through most of H2 2022. Since our last update on December 13 2022, the S&P 500 is down 0.2%. The 10-year Treasury yield – a key valuation metric – is down 2bp to 3.48%. We summarise our views in Table 1 above and Table 3 at the end of this article.

Most sectors are little changed as investors wait on 4Q earnings reports and economic data that might push equities higher or lower.

We are neutral on equities for now in our asset allocation framework. Equites remain in the trading range of the past two quarters pending some catalyst that pushes them higher or lower. We see risks tilted to the downside. Several banks are warning of a mild recession in 2023, and company outlooks for 2023 are cautious. Apart from sluggish growth, earnings reports so far suggest companies will face growing headwinds from higher costs. In any case, upside is limited while the Fed is raising rates and fighting inflation.

This environment is unconducive to robust earnings growth. Analysts are pencilling earnings growth in 2023 of 8.5% for the S&P 500 and 14.6% for the NASDAQ 100. To achieve that, much must go right in what is shaping up to be a challenging year.

We made no changes to our recommendations since our last update.

We summarise our views about each trade in the sections below.

Portfolio Updates

Major Indices

We are long the S&P 500 (SPX) versus short the NASDAQ 100 (NDX) and Russell 2000 (RTY). Investors can execute these trades via the SPY, QQQ, and IWM ETFs, respectively.

Until the economy enters recovery mode, growth stocks and small companies will struggle. Based on current earnings projections, we think the SPX is trading close to fair value, and the NDX and RTY are overvalued by 9.6% and 9.0%, respectively. If we are correct that earnings growth will be weaker, the NDX and RTY indices have further downside relative to SPX.

SPX Sectors

Communications (XLC) – We have recommended a long position in the communications sector ETF (XLC) versus short SPY. This trade is down 8% since inception but up 9% over the past month. This sector includes hard-hit names like Netflix (NFLX), Google (GOOG), and Meta Platforms (META).

We recommend XLC because it is undervalued by more than 25%. Analysts are now assuming earnings in 2023 will be flat to 2022, so our valuation metric is conservative. This position may be volatile in coming months, but we expect it will perform strongly over the medium term.

Consumer Discretionary (XLY) – We are short XLY versus SPY. This position is up 16% since inception. XLY is overvalued by 25% – and that is relative to an extraordinary 28% jump in projected earnings in 2023. If earnings growth proves weaker then XLY is even more overvalued. We expect XLY to continue underperforming in coming months.

Consumer Staples (XLP) – We have been short XLP because it appeared overvalued by our metrics. The trade performed poorly for much of 2022 but gained 7% in the past month. It is now down 2% since inception and trading close to fair value.

We are considering unwinding this trade as we now expect it to perform largely in line with SPX.

Energy (XLE) – We are long XLE versus SPY. This is our favourite long trade. It is up 26% since inception, yet it remains massively undervalued relative to SPY – by 34%. Investors have not priced in the pivot many energy companies have made: to prioritise returning capital to investors instead of ploughing profits into exploration and development. To cite one salient statistic, the free cashflow yield for XLE is about 7% versus a long-term norm of around 1%.

Financials (XLF) – We are long XLF versus SPY. This trade is up 6% since inception and 2% over the past month. Banks are benefiting from higher net interest margins, and this benefit will remain while the Fed is raising rates. Once the Fed pauses, deposit rates will catch up and margins shrink. But that day has yet to come.

Healthcare (XLV) – Our long position in XLV is up 7% versus SPY but down 5% in the past month. By our metrics, XLV is undervalued by 9%. We recommend maintaining this position.

Industrials (XLI) – Our long position in XLI versus SPX is up 11% since inception. It is trading near fair value. We are considering unwinding this trade as we expect it to perform in line with SPX for now.

Materials (XLB) – We have been long XLB versus SPY, and this position is up 3% since inception. We are considering unwinding this position. Analysts expect earnings to fall 15% in 2023, largely because of rising cost pressures. As such, XLB has gone from being undervalued to overvalued by 15%.

Real Estate (XLRE) – Our long real estate position is down 11% since inception due to the pressure of higher rates. We had expected the shortage of housing would cushion the sector, but the SPX real estate sector includes commercial as well as residential real estate. We look for XLRE to recover in the medium term.Technology (XLK) – Our short position in XLK is now up 1% versus SPY. We expect growth-oriented companies in this sector will remain under pressure while the Fed is raising rates. XLK is overvalued by 15% by our metrics. We will re-evaluate this position as tech companies report earnings.

Utilities (XLU) – XLU is up 1% versus SPY since inception and down 6% over the past month. The poor recent performance may reflect weather-related issues. We maintain this position for now given utilities tend to outperform in weaker economic environments.

Theme Trades

Clean Energy

Our clean energy trades remain our worst-performing trades, down 9% versus SPY since inception. Many ETFs in the clean energy space hold Chinese companies, which have been exposed to the Covid-related selloff in China equities. If the reopening takes hold later this year, many of these equities should recover.

We view this as a long-term and patient trade.

Financials

The insurance sector (KIE) is one of our best performers, up 14% versus SPY. We still like this trade. Our short position in major banks (KBWB) has performed well, up 8%; however, our long position in regional banks (KRE) is down 6%. Regional banks have outperformed major banks by 6%.

Growth Versus Value

We remain long value (RPV) versus growth (RPG). This trade is up 28% since inception.

Homebuilders

Our short position in homebuilders (XHB) versus SPX is up 9% since inception but down 3% over the past month. We are considering unwinding this trade. Recent homebuilder earnings reveal a weak housing market but also an industry that can still operate profitably.

Reopening Trades

Our reopening trades are mixed. JETS is up 3% since inception – and a huge 12% over the past month on strong earnings and outlooks from airlines. We expect JETS to continue outperforming. PEJ holds companies that should do well as people get out more, including casinos, theme parks, sports venues, and restaurants. This ETF is down 8% since inception – but up 6% over the past month. We will hold it for now.

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.)