Equity Trades: Exit Retail and US Infrastructure

Summary

• Our ETF-based portfolio is up 1.5% since its inception, and 4.8% excluding the clean energy sector. We outline our views about each of our trades in this note.
• We are unwinding the short retail (XRT) position and traditional US infrastructure trades because we expect them to perform in line with the market going forward.
• We maintain a short position in homebuilders due to the risk of rates rising further and the economy slowing. We keep long positions in travel and leisure ETFs because recent earnings reports show the reopening trade is still in full swing.

Market Implications

• We continue to underweight equities in our broader asset allocation framework because we think the Fed will continue raising rates until the economy and labour market slow significantly.
• We expect equities to trade in a range for now, with a bias towards the downside after last week’s rally following the weaker-than-expected inflation report.

Introduction

As of 11 November 2022, our recommended trades are up 1.5% versus 0.9% on 18 October 2022. Excluding the clean energy sector, they are up 4.8%. All major subsectors contributed to the gain, except financials. Our short position in major banks versus the S&P 500 (expressed via ETFs KBWB versus SPY) underperformed because solid net interest margins at banks offset weak investment banking results.

See the table at the end of this note for a summary of all positions. We present our trade methodology here.

Some Portfolio Changes

Unwind Short Retail

We are unwinding our short retail position (XRT) versus a long in SPY. This trade has outperformed by 33% since its inception on 9 June 2021. It has traded in a narrow range since early summer. We expect it to perform roughly in line with SPY or modestly better going forward, given continued strong retail sales and the apparent ability of companies to pass on higher costs to consumers.

Unwind Traditional Infrastructure

After the Infrastructure and Jobs Act was signed into law (15 November 2021), we initially recommended long positions in several ETFs focusing on US traditional infrastructure. These included PKB (-7%), IFRA (+19%), and PAVE (15%) (returns versus short SPY). PKB focuses more on commercial real estate and has been hit by higher rates and materials costs.

PKB and IFRA have traded in a narrow range in recent months. PAVE has rallied about 6% over the past two months. We do not expect traditional infrastructure to continue to significantly outperform SPY.

Unwind Semiconductor Short

Earlier this week, we unwound our short position in semiconductors (SOXX) versus a long in SPY. It has outperformed by 26% since its inception on 6 October 2021, largely because of high inventories and weaknesses in large manufacturers of consumer electronics. Inventory problems are likely to clear up in the coming months.

Recent earnings reports show semiconductor and tech companies are doing well or outright thriving, particularly those that focus on migrating Corporate America to the cloud and upgrading its technology. We expect this will become increasingly important. We will seek an opportunity to re-establish a long in semiconductors.

Ongoing Trade Updates

Major Indices

Long SPY/QQQ (+5.5%) – We are comfortable with being long the S&P 500 (SPY) versus the NASDAQ 100 (QQQ). As long as the Fed is raising rates and the economy is at risk of significant slowdown or recession, the tech sector will be under pressure. Also, the mega-tech companies with advertising-driven business models – for example, Alphabet (GOOG), Meta Platforms (META), and Twitter (TWTR) – are experiencing disruption because Apple (APPLE) allows users to opt out of tracking. That makes it difficult to deliver targeted ads and is hurting revenue.

Long SPY/Short RTY (-2.5%) – Our long SPY versus short Russel 2000 has bounced between the black and the red. Analysts project earnings of $78.74 in the year ahead versus 12-month trailing earnings of $22.14. In other words, there are many loss-making companies in the Russell 2000, and analysts expect many to return to profitability. That will not happen if the Fed keeps raising rates and the economy slows or enters recession. We expect to maintain this short until it becomes apparent the economy will avoid recession.

Long SPY/Short SX5E (-7.4%); SXXP (-1.9%); UKX (-2.0%) – We took short positions in three major European equity indices on 28 July 2022. We did so because of the growing likelihood of a recession in Europe and because analysts were projecting very aggressive year-ahead earnings. Granted, the indices appeared (and remain) cheap relative to projected earnings. But our view then was that as earnings projections fell, so would the indices. More likely, equities already priced in the bearish scenario far ahead of analysts.

We will maintain this position for now, but we no longer expect them to perform significantly worse than the SPY.

Taking currencies into account (short EUR, long USD), SPY outperforms the European indices. But we are focusing on equity returns, not FX effects.

SPX Sectors

Long Communications (XLC)/Short SPY (-13%) – This is our worst sector trade. We took a long (and contrarian) position in XLC because it appears to be at least 15% cheap relative to trailing and projected earnings. Since then, it has sunk more than 30%.

This sector includes mega-tech companies Alphabet (GOOG) and Meta Platforms (META), as well as traditional telecoms like AT&T (T) and Verizon (VZ). Those large companies have disproportionately weighed on performance. At this point, most of the bad news is probably priced, and we will follow the model and maintain this position for now.

Long SPY/Short Consumer Discretionary (XLY) (+11.9%) – Unlike communications, the consumer discretionary sector continues to be overvalued relative to earnings by some 35%. This is despite projected earnings growth having fallen from nearly 40% in early 2022 to 12% recently.

Long SPY/Short Consumer Staples (XLP) (-2.4%) – Conventional wisdom dictates that investors should favour the consumer staples sector in a recessionary environment. While people can forego boats and cruises when times are tough, they still must eat and replace worn-out shoes. We took a short position because it appeared 10% overvalued. It has moved closer to fair value recently, and we will consider unwinding this position soon.

Long Energy (XLE)/Short SPY (+28.1%) – This is our favourite long position. Energy continues to be significantly undervalued relative to earnings by an order of 40%. We doubt the price performance will close this gap given the historical volatility of the energy sector. The valuation gap could just as easily tighten because of lower energy prices and earnings, although this appears unlikely in the foreseeable future.

Apart from some potential price performance, returns in the energy sector will come mostly from dividends and share buybacks. In a major change from previous cycles, US energy companies have committed to returning capital rather than ploughing profits into exploration. There was no indication in recent earnings releases that this has changed.

Long Financials (XLF)/Short SPY (+6.85) – As long as the Fed is raising rates and banks can increase their net interest margins (NIM), they should outperform. The problems may come when the Fed pauses, deposit rates catch up and squeeze NIMs, or if the economy slows and loan delinquencies and defaults rise. We maintain this position for now.

Long Healthcare (XLV)/Short SPY (+5.5%) – This low beta sector should continue to outperform in a slowing economy. It is trading cheap to projected earnings.

Long Industrials (XLI)/Short SPY (+9.4%) – Industrials are trading near fair value. We see no reason to change this position for now.

Long Materials (XLB)/Short SPY (+0.2%) – With the global economy generally slowing, conventional wisdom again suggests demand for materials should soften with a knock-on impact for materials equities. We have taken a contrarian position because materials appears undervalued by about 9% in our model. This position has been about 5–8% in the red for much of the time since its inception (14 April 2022) but has recovered recently.

Long Real Estate (XLRE)/Short SPY (-12.7%) – We have been long real estate, partly because it appears cheap in our valuation framework and partly because the general shortage of residential housing makes it unlikely that vacancies will be a problem for the foreseeable future. However, the sector has been vulnerable to rising rates. And it includes subsectors other than residential, such as commercial, which have fared worse due to the pandemic and working from home. We maintain this position due to the cheap valuation.

Long SPY/Short Technology (XLK) (+0.3%) – This trade was up about 5% in early November but is now close to flat after last week’s tech rally. We maintain this position because of a rich valuation and our expectation of a slowing economy.

Long Utilities (XLU)/Short SPY (-1.7%) – This trade was up about 10% in early September but has steadily lost ground since the 10-year Treasury yield crossed 3.25%. Conventional wisdom favours utilities in a slowing economy and recession because, like consumer staples, people need heat and electricity whatever the economy’s state. But the problem for utilities is that they have generated negative free cashflow for the past seven years and steadily added debt (and leverage) to maintain dividends. We expect utilities to perform roughly in line with the broader market for now.

Clean Energy

Our clean energy trades have been the worst performer, down an average of 11.4% since their inception in August 2021. We entered these trades in the aftermath of the COP (Conference of Parties) climate meetings in Glasgow. They initially performed well but lost ground in 2022 for several reasons.

First, the war in Ukraine and resulting oil and gas shortages reminded people of the need to maintain fossil fuel supplies for the foreseeable future. Second, many clean energy ETFs have exposure to China, where equity markets are down a third, largely due to ongoing Covid lockdowns. Third, many clean energy companies are still in loss-making mode, which is challenging in a rising rate environment.

We will publish a more detailed note about clean energy ETFs soon. For now, we view this as patient, longer-term trade.

Homebuilders

Our short position in homebuilder ETF XHB is up 11.9% versus SPY since its inception on 28 May 2021. With 30-year fixed-rate mortgages above 7%, homebuilding will be depressed until either rates fall significantly, or home prices fall sharply. The good news is that, unlike in the late 1980s and 2008, most homebuilders do not have large inventories of speculative unsold houses. They should be able to continue operating profitably, albeit modestly. We look for homebuilders to perform in line with the broader market for now, with downside risks if, as we expect, rates rise further and the economy slows.

Travel and Leisure

Our travel and leisure selections, JETS (airlines) and PEJ (casinos and other entertainment), have returned an average of -8.7% since 3 November 2021 but have recovered +2.8% in recent weeks. We were considering unwinding these positions, but recent earnings reports show demand for travel and entertainment remains strong. We maintain these positions 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.)