Trade Update: Turning Short Industrials and Materials

Summary

• We are unwinding long positions in industrials (XLI) and materials (XLB). Both have outperformed the S&P 500 since inception on April 2022.
• The industrial sector is facing a steep 24.5% climb in earnings in 2023 and is priced to reflect that scenario. Between rising cost pressures and a slowing economy, we doubt industrials can deliver those earnings.
• In the materials sector, analysts have cut forward earnings by 14% relative to 2022 trailing earnings. Materials equities are yet to reflect that more bearish scenario.

Market Implications

• We will now be short XLI and XLB versus the S&P 500 (SPY).

Introduction

We are unwinding and reversing two S&P 500 sector trades based on recent performance and our outlook – a long position in industrials (XLI) and materials (XLB), both against the S&P 500 (SPY).

Industrials

We have been long XLI since 13 April 2022. It performed well, up as much as 15% in early 2023; it is now up 11% (Chart 1). We entered the trade partly because it appeared cheap and partly because many names in the sector are value stocks, which were outperforming growth stocks. 

We exit the trade because we think forward earnings for 2023 are calling for a steep 24.5% increase over 2022 trailing earnings (Chart 2). We acknowledge that XLI is arguably cheap or fair value relative to forward earnings. However, cost pressures are already becoming apparent in Q4 earnings releases, and demand for industrial goods is softening – especially on the consumer side. Therefore, we doubt that realised earnings can match that aggressive outlook. We expect XLI to underperform relative to SPY.

Materials

We entered a long position in XLB also on 13 April 2022. It was down 6-7% during the summer, then rallied in autumn on strong earnings. It is now up 3%. We entered the trade because many companies are in the value sector and it appeared slightly cheap.

We exit the trade because forward earnings dropped 12% in January. Essentially analysts are saying that the strong pricing due to supply-chain problems in 2022 are easing. In addition, the prospect of a slowing economy and cost pressures make it more likely 2023 earnings will be lower than 2022.

The market has not priced in this more bearish earnings scenario.

We are reversing this trade to be short XLI and long SPY.

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.)