Equity Trades: Launching a New Framework

Summary

• We revise our format for presenting equity trade ideas and performance to date statistics for outstanding trades.
• We are now presenting trades in long/short format rather than over/underweight or market-weight.
• Our longs have outperformed shorts by an average of 0.9%. Excluding the clean energy sector, which has been exceptionally weak recently, longs would be up an average of 4.4%.
• Our focus is on trades within equities. In a broader asset allocation framework, we remain underweight equities given rising rates, recession risks, and elevated geopolitical tensions.

Introduction

With this note, we revamp our framework for equity trades and present a report on performance since inception. We plan to publish this report regularly.

The primary change is that we now present trades in a long/short format where each trade is equally weighted. Our goal is to offer trade concepts that investors can implement in the context of their portfolios. For example, a long-only investor can overweight the long leg and underweight the short leg and weight it according to their views and rules. See the Appendix 2 for a more detailed explanation.

Previously, we presented trades as overweight, underweight or market-weight. This has been problematic because it raises questions about how much to over/underweight, and how to measure performance.

Performance to Date

The table in Appendix 1 summarises the performance to date of the trades referenced in the table above. Overall, the long leg has outperformed the short leg by an average of 0.9%. Excluding the clean energy sector, longs would have outperformed by an average of 4.4%. We discuss our current views about these trades in the sub-sections below.

Indices

We entered five index trades on 28 July 2022, with the S&P 500 as the long leg. On the short side were the NASDAQ 100 and Russell 2000, and several European indices – the Euro STOXX 600 (SXXP), Euro STOXX 50 (SX5E) and FTSE 100 (UKX).

We had expected European equities would underperform given Russia’s invasion of Ukraine and the ongoing energy crisis. But they have outperformed the SPX. Especially surprising has been the UKX given the turmoil in the Gilt market and UK government. It is up 3.4% relative to the SPX, although down 2.8% in the past week.

S&P 500 Sectors

We express these trades using ETFs that track each sector. Note that returns are relative returns – they express how the long leg performed relative to the short leg. Communications, for example, returned -8.2% over the trade horizon and the SPX returned -1.1%, resulting in a relative return of -7.2%. When we discuss a group of trades (e.g., clean energy) returns are an average of relative returns across all trades.

Communications (-7.2%) – We moved communications to long on 20 June 2022 because it was – and continues – to look very cheap relative to earnings. But it has continued to underperform in a down market. This sector is a mix of glitzy 21^st-century companies such as Google (GOOG) and Netflix (NFLX) and old-line media and telecom companies such as News Corp (NWS) and Verizon (VZ). It is dominated by Google (GOOG), which accounts for about a third of the index. As GOOG goes, so goes the sector. We will re-evaluate this position after GOOG reports earnings next week.

Consumer Discretionary (+6.0%) – This sector is a mix of companies that are doing well in the current environment as the economy reopens and those that did well during the Covid lockdowns. On balance, losers have outweighed winners.

Consumer Staples (-3.3%) – This sector typically does well in a slowing economy as people still need to buy food and other necessities. But we moved to short because it is very rich relative to current and projected earnings, making it unlikely that it can outperform significantly in a down market while being vulnerable in a rally.

Energy (+21.1%) – This is our favourite long position. Even though it is up 21%, it remains very cheap relative to current and projected earnings,

Financials (+3.3%) – Financials are benefiting from high interest rates for now. We will move to short if at some point we see liability costs rising, or a slowing economy is leading to higher credit costs.

Healthcare (+7.7%) – The healthcare sector has been able to pass on rising costs and provides ongoing essential services.

Industrials (+4.7%) – So far, there is little sign of weakness. We are long industrial expect this sector to perform in line with or better than the broader SPX.

Materials (-5.6%) – This long position has underperformed because the Covid-related slowdown in China has persisted longer than we expected, cutting demand for many basic materials. In addition, slower economic growth and the rising dollar has hurt demand in many countries. Balanced against that is rising demand for materials such as copper and lithium for clean energy investment. We may move this to short soon.

Real Estate (-14.1%) – We have been long real estate on expectations that a housing shortage would support real estate prices and rents. But the sector also encompasses commercial real estate and retail malls. Given the role of leverage in real estate, rising interest rates have hurt the sector.

Technology (+2.4%) – We are short Technology because the higher beta tech sector is vulnerable in a down market. The ban on selling high-tech products to China also raises uncertainty for now.

Utilities (-0.5%) – We are long because we expect utilities to perform roughly in line with or better than the broader SPX.

Sector Views

Clean Energy (-13.4%) –  We first recommended these going long a selection of clean energy ETFs last August after the International Panel on Climate Change (IPCC) issued a blunt assessment of the risk that global temperatures could rise well above the critical 1.5°C threshold unless countries take immediate steps to control emissions. We counselled then that this is a patient trade.

This sector has fluctuated since then with the outlook for clean energy legislation and in response to extreme weather events and the energy shock after Russia invaded Ukraine.

It has performed particularly poorly in recent weeks. Many companies in this sector are still in loss-making mode. As interest rates rise, a higher discount rate makes distant cash flow less valuable. In addition, more immediate concerns about fossil fuel prices and supplies have taken focus off the clean energy sector.

We maintain our long positions on expectations that the sector will recover.

Financials (+8.9%) – Financials are up an average of 9.2%. We are long insurance and regional banks, and short major banks. The regional banks are benefiting from higher rates and still-strong loan demand. These factors are boosting major banks too, but investment banking is weak, and capital market earnings are volatile.

Travel/Leisure (-10.6%) – We have been long this reopening theme since last November. This sector is down about 10.5% as concerns about the economy and inflation have risen. The airline sector took a hit when jet fuel prices jumped, but it is becoming apparent that air travel remains in strong demand, and airlines are reporting solid holiday bookings. And the leisure-oriented PEJ ETF holds many companies that are destinations that people want to go to. As long as the labour market remains robust, we expect people will continue spending on travel.

Homebuilders (+8.4%) – We are short homebuilders because of negative sentiment about housing. Given the housing shortage in the US, we believe homebuilders can still be profitable in this environment, so we view this as a tactical rather than fundamental short.

Semiconductors (+24.7%) – We are short the semiconductor sector because of excess inventory problems at many of their customers, and uncertainty about the impact of the ban on selling advanced technology to China.

US Infrastructure (+6.8%) – US infrastructure equities have mostly done well since the Infrastructure Investment and Jobs Act was signed into law last November.

Appendix 1 – Outstanding Trades

Appendix 2– Our Trade Methodology Explained

This appendix summarises our methodology for making trade recommendations and measuring performance.

Our goal is to present trade concepts that investors can implement in the context of their portfolio. We implement trades as long/short combinations, and we assume each trade is equally weighted.

Many investors may not take short positions, or may set larger or smaller trade sizes relative to the trade’s weighting in an index. Our long/short positions can instead be implemented by overweighting one leg and underweighting the other, and trades can be sized according to an investor’s views portfolio requirements.

At this time we measure performance based on price changes rather than total returns or price changes plus dividends. We generally do not expect trades to be in place long enough for dividends to make a material difference.

Our trades may be fundamental or tactical. Fundamental trades tend to be longer term and reflect expectations about the economy or sector or a belief that something is over/undervalued. Tactical trades seek to take advantage of shorter term dislocations.

Long/Short Positioning

We present trades as long one leg and short the other. Both legs are equally weighted. Our expectation is that the long leg outperforms the short leg.

For index and S&P 500 sector trades we do not have a market-weight category. A market-weight position is an implicit long position. The expectation is that a long position in an index or sector will perform in line with or better than the short leg.

Performance Measurement

We measure trade performance on the basis of price changes since inception. The since inception performance is the percent change in the long leg price divided by the percent change in the short leg price:

Where:

We measure performance across trades as the average return:

Where:

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.)