Pithy market aphorisms are abundant. Perhaps a good one to characterise the current conditions is that markets climb a wall of worry. After rising 7.7% from an early October low over the past two weeks, markets have wrestled with inflation that is proving more persistent than many thought back in summer and a 10-year Treasury yield that seems anchored around 1.55%, causing real yields to plunge to a negative 1.17%. And concerns linger over how the Fed will respond – plus the (as yet unlikely) prospect of new leadership.
Despite those concerns, it has been a sparkling 3Q earnings season. S&P 500 companies beat projections by 9.4% and the Russell 2000 by a massive 62%. As we reported last week, companies have been able to pass on higher costs to customers, keeping margins much higher than expected. The elections in early November sent a clear message that voters have lost all patience with Covid-related restrictions and mandates. Politicians will surely err on the side of fully reopening the economy. Whether that is in the best interest of public health remains to be seen; it is bullish for the economy and equities.
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Pithy market aphorisms are abundant. Perhaps a good one to characterise the current conditions is that markets climb a wall of worry. After rising 7.7% from an early October low over the past two weeks, markets have wrestled with inflation that is proving more persistent than many thought back in summer and a 10-year Treasury yield that seems anchored around 1.55%, causing real yields to plunge to a negative 1.17%. And concerns linger over how the Fed will respond – plus the (as yet unlikely) prospect of new leadership.
Despite those concerns, it has been a sparkling 3Q earnings season. S&P 500 companies beat projections by 9.4% and the Russell 2000 by a massive 62%. As we reported last week, companies have been able to pass on higher costs to customers, keeping margins much higher than expected. The elections in early November sent a clear message that voters have lost all patience with Covid-related restrictions and mandates. Politicians will surely err on the side of fully reopening the economy. Whether that is in the best interest of public health remains to be seen; it is bullish for the economy and equities.
Disney’s (DIS) 24% earnings miss on weaker-than-expected new subscriptions to its Disney+ streaming service encapsulates the transition happening in society. People are shifting away from at-home entertainment. But they have not quite shifted their consumption dollars from goods to the kinds of services and leisure activities that should benefit DIS in coming quarters, with its movie production sets and theme parks.
On the worries, we still see the silver lining. Inflation will probably ease only gradually – but consumers have a remarkable ability to substitute cheaper for more expensive things, so many will be able to avoid the worst of the headline numbers. In particular, goods inflation could accelerate the shift from spending on goods to services.
The Fed will always be a worry. Whatever they say about keeping rates low indefinitely, central banks always tend to err on the side of caution by taking away the proverbial punchbowl. We think they will again err on the side of caution – but this time their caution aims to avoid doing something that brings on the next recession. We view selloffs on worries about premature rate hikes as buying opportunities.
We are updating some of our trade recommendations:
- We turn neutral on the S&P 500 (SPY, overweight) versus financials (XLF, KRE, KBWB, underweight). SPY is up about 5% since initiating this trade on 20 May. If the 10-year Treasury yield rises even modestly, financials will likely outperform. Several regional banks reported expectations of stronger loan growth in 4Q. We are sceptical of that. And given loans are priced off the curve’s short not long end, banks will get little relief on the yield front until the Fed starts raising short rates. If rates rise and financials outperform, we would reinstate this trade.
- In the S&P 500, we stay constructive on growth versus value. We see little prospect of value outperforming while the labour market remains weak.
- Homebuilders have largely recovered against the broader market, and underlying fundamentals remain robust due to low rates and tight housing supply. We maintain our long on XHB.
- We stay negative on retail. It is losing a key source of support as extraordinary unemployment benefits expire. If anything, high goods inflation should accelerate the shift to services.
- We added three new trades – overweight PEJ/JETS/AWAY; underweight XRT. Voters sent a clear message during the recent elections that they want an end to Covid-related restrictions and mandates. We believe the reopening trade will accelerate and consumer spending will shift from goods to more fun activities. We recommend underweighting the good-oriented XRT ETF, and overweighing PEJ (leisure activities), JETS (airlines) and AWAY (internet-based travel services).
- In the clean energy sector, FAN (wind power) has underperformed (-8%), while hydrogen ETFs (HDRO, HJEN) are up about 15%. Wind has received negative press as weak winds have contributed to Europe’s energy crisis, and hydrogen received good press at COP26. We suggest trading-oriented investors underweight hydrogen and overweight wind. Table 1 shows the performance of our sector trades since inception.
We summarise our latest thinking on each sector view in the remaining sections.
S&P 500 Growth (L) vs Value (S)
Initiated 26 April 2021 After initially struggling, growth has outperformed value by 10%. We do not see growth running away from here, but value will continue to underperform while businesses cannot hire enough workers. For smaller companies to thrive, we need sustained improvement in labour force participation.
Long SPY / Short XLF
Initiated 20 May 2021 We are closing out this trade. If longer rates rise, as is likely, financials may outperform. We think financials will remain under pressure until the Fed starts to raise short rates. We would view any significant outperformance as an opportunity to reinitiate this trade.
Long SPY / Short KRE (Regional Banks)
Initiated 20 May 2021 We are closing out this trade. If longer rates rise, as is likely, financials may outperform. We think financials will remain under pressure until the Fed starts to raise short rates. We would view any significant outperformance as an opportunity to reinitiate this trade.
Long SPY / Short KBWB
Initiated 20 May 2021 We are closing out this trade. If longer rates rise, as is likely, financials may outperform. We think financials will remain under pressure until the Fed starts to raise short rates. We would view any significant outperformance as an opportunity to reinitiate this trade.
Long XLF / Short KBWB
Initiated 20 May 2021 We are closing out this trade. If longer rates rise, as is likely, financials may outperform. We think financials will remain under pressure until the Fed starts to raise short rates. We would view any significant outperformance as an opportunity to reinitiate this trade.
Long XHB / Short SPY
Initiated 28 May 2021 We recommended going long homebuilders on the strength of the housing recovery, low rates, and a housing inventory shortage. There is some risk of rising mortgage rates when the Fed slows purchases of MBS, but underlying fundamentals are still attractive.
Long SPY / Short XRT
Initiated 10 June 2021 Retail sales received a huge boost during the pandemic because people needed stuff. Retail rallied in early November, apparently on the strong earnings from a couple of consumer-oriented companies, but we expect this will soon reverse.
Long PEJ/AWAY/JETS / Short XRT
Initiated 3 November 2021 A clear message from the recent elections is that Americans want an end to Covid-related restrictions and mandates. We believe the reopening trade will accelerate, with consumers increasingly shifting to leisure and travel-related spending. We recommend overweighting PEJ (leisure activities), JETS (airlines) and AWAY (internet-based travel services) and underweighting XRT (goods-related retailers).
Clean Energy
Clean energy ETFs are mostly doing well exiting COP26. The key question will be whether and when significant new money flows into the sector.
We expect many countries will be slow to start honouring their commitments, which could put downward pressure on clean energy equities.
But as ongoing evidence of climate change mounts, we expect the money will start to flow.
We recommend investors start accumulating positions in clean energy ETFs. We stress this is a patient trade, but we see significant upside in this sector over the coming decade.
Long FAN / Short HDRO or HJEN
Initiated 11 November 2021
The FAN ETF (wind power) has underperformed recently. Negative press about how weak wind power has contributed to Europe’s ongoing energy crisis is the probable cause. Meanwhile, hydrogen ETFs have soared thanks to favourable mentions during COP26.
We recommend trading-oriented investors overweight FAN and underweight either HDRO or HJEN. Hydrogen has long-term promise, but many technical barriers lie ahead. Wind is here, and scaling rapidly.
Long SOXX / Short SPY or QQQ
Initiated 6 October 2021 The semiconductor industry has been in the news frequently in 2021 due to tight supplies that have hamstrung the auto industry in particular. This stems from a surge in demand for digital consumer products since the pandemic hit in March 2020.
The industry is enjoying pricing power for the first time in 30 years. Further, demand will likely remain strong in coming years as electric vehicles and other clean energy technology come online. We think semiconductors can outperform the broad equity (SPY) and tech (QQQ) markets over the medium term.
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.)