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Trading Lesson: Rockin' Reflation in Short Trade Idea on Industrial XLI
05/18/2018 3:09 pm EST
Trade Idea: As long as XLI trades below $77.31, then new short trade ideas can be initiated opportunistically on rallies. Depending on how much room you want to give this trade idea to move, use a risk price between $74.36 and $77.31, writes Landon Whaley.
Financial markets are always full of headline risks, but last week was particularly heavy in this regard. I hope you weren’t one of the many investors who got roped into the latest Trump-related drama involving Iran.
Did the Iran situation whip crude oil around a little bit? Sure, but as all things Trump have proven over the last year and a half, it’s a big nothing burger in terms of financial market impact beyond a few days.
As our clients know, there are two chief variables that impact the direction of asset prices: one is economic conditions, and the other is how central banks respond to those conditions. Together, they drive what we call an economy’s Fundamental Gravity.
Financial markets don’t bob around rudderless; rather, they behave like a flock of birds. In a flock, hundreds of birds rise and dive together, but there are just a few birds at the front dictating the direction of the entire flock. In financial markets, the first bird driving the risk and return of asset prices is economic conditions, and the second is central bank policy.
Most investors have limited insight into what’s really happening from a fundamental perspective. Furthermore, any Fundamental Gravity-based knowledge that could potentially guide their investing decisions is often obscured by their emotions, or what we refer to as their “humanness.”
The most critical development last week was the latest U.S. inflation reading. If you’re in the habit of getting your information from the media, then you’re lost before you even begin. The media spins narrative about economic data, and the way they portray or interpret it is rarely accurate.
A perfect example of this is the headline following last week’s April inflation report:
CNBC – “US Treasury yields drop after inflation data misses expectations.”
MarketWatch – “Dollar headed for 2nd day of losses after weaker-than-hoped inflation data.”
Kitco – “Gold prices see brief pop following disappointing U.S. inflation data.”
Reuters – “Dollar, yields slide on soft US inflation.”
These headlines and their accompanying commentary completely missed the boat. In this case, “the boat” is the fact that U.S. inflation accelerated for the third consecutive month and is now sitting at the highest level since 2012! And don’t believe the hype that U.S. inflation is being driven higher entirely by energy. Prices are rising across the U.S. economy, including medical, cell phone services, rents and food.
Not only is inflation ramping, along with U.S. yields, but now the greenback has also come out to play.
The playbook for trading a U.S. Fundamental Gravity characterized by this trifecta is straightforward. In the most general terms, you want to be long energy-related equities and avoid (or opportunistically short) U.S. sectors like consumer staples and industrials. Oh, and you don’t want to touch anything related to emerging markets. EM equities, currencies and bonds are all bearish kryptonite right now.
In this week’s Macro Theme, I’m going to review one of our currently active themes that takes advantage of the current U.S. Fundamental Gravity: Rockin’ Reflation. We are already long SPDR S&P Oil & Gas Exploration ETF (XOP) in our Asset Allocation Model, and we are now going to add a short position to go along with it.
NZT 48 for XLI
This week our smart pill snapshot explains why shorting the Industrial Select Sector SPDR ETF (XLI) makes sense in the current macro environment.
The reflation trade has been “on like Donkey Kong” for the last month, and has legs for at least two more months. Our “Rockin’ Reflation” macro theme, which I rolled out on April 16, has sent us long the SPDR S&P Oil and Gas Exploration ETF. This trade already has us in the green by more than 10%.
This week we are adding another position to our Asset Allocation Model to take advantage of this macro theme. However, this time we are shifting to the short side, with the Industrial Select Sector SPDR ETF.
This asset management call is simple: corporate earnings are at a cyclical peak, while both raw material and wage costs are accelerating. To add fuel to this bearish fire, this domestic economic reality is occurring against a backdrop of slowing global growth.
This economic equation means industrial companies with no pricing power are going to be squeezed where it hurts most: in their wallets.
This is a decidedly bearish Fundamental Gravity, which means it’s time to put on a short trade and go huntin’ for wabbit.
As long as XLI trades below $77.31, then new short trade ideas can be initiated opportunistically on rallies. Depending on how much room you want to give this trade idea to move, use a risk price between $74.36 and $77.31. That said, your risk price line in the sand is $77.31; if XLI closes above that price, exit any open trades. If the trade moves in your favor, then consider closing some, or all, of your position using the price area around $69.38 as a profit target.
Fundamental Gravity says what?
The Fundamental Gravity in the United States right now is being driven by inflation. The growth side of the economic equation is shifting to a slowdown as we make our way toward the second half of the year, but for now it remains buoyant. However, the inflation side of the equation is in a clear uptrend and is poised to move higher.
You don’t have to be Nostradamus to know that inflation is likely to head higher in the coming weeks. Commodities across the board are ripping to the upside: crude oil is +16.2% year-to-date, corn is up 10.6%, lumber is crushing it up 37%, and even orange juice is up 15.9% this year. And it’s not just commodity prices that are ramping: medical, shelter, wireless services and food are all accelerating.
The new Fed Chair, Jerome Powell, is a data-dependent guy, which is a drastic departure from his last two predecessors, who were stock market-dependent.
Powell’s data dependency will leave him sounding extremely hawkish anytime a microphone is shoved in his face. The Fed’s hawkish tilt and continued rate hikes (another one in June) will likely be a divergence from the policy stance of two other major central bank players, the People’s Bank of China and the ECB.
Both central banks will likely stay on a course to normalization, but will plant themselves evenly between dovish and hawkish, being careful not to tilt one way or the other. This slight divergence between the Fed and the other two major central banks will be enough to put a continued tailwind behind both U.S. yields and the U.S. dollar.
Adding a stronger U.S. dollar to this cocktail of higher inflation and higher U.S. yields produces a recipe for an XLI hangover.
The Fundamental Gravity bottom line is that industrial companies’ profits are getting ready to be squeezed by a strong greenback, higher material costs and late cycle wage growth. That is a bearish triple whammy!
Quantitative Gravity says what?
As a quick reminder, the Quantitative Gravity component of our Gravitational Framework is not technical analysis, which is ineffective and misleading. Rather, we use quantitative measures that are based on the reality that financial markets are a nonlinear, chaotic system.
We’ve identified four primary quantitative dimensions of financial markets that affect price movement: energy (trend), force (momentum), rate of force (buying pressure), and a market’s irregularity.
Social is our measure of a market’s current energy, or trend. XLI’s Social reading is indicating it’s in a hangover. This is a bearish trend in which it has become an entrenched.
Momo is our measure of the amount of force behind the market’s current state. XLI’s Momo has been negative since late January and is getting more bearish as we move through time.
Barometric is our measure of the rate of force behind the current Momo. XLI’s Barometric meter reached an extreme bearish reading in April. That selling pressure has abated somewhat, but make no mistake, the sellers are still in control of this market.
Topo, which measures the probability of a drawdown, is indicating a rising probability of a drawdown over the next ten trading days.
When a market is rallying, then a declining Topo confirms the upswing. On the flipside, if a market is falling, a rising Topo is the confirmation signal that the downtrend is more than just a pullback.
XLI’s current rally off the May 3 low has been accompanied by a rising Topo, which indicates this is nothing more than a countertrend rally that is not to be trusted, but absolutely shorted.
Most investors are hyper-focused on price action. Unfortunately, price is nothing more than the current point where there are equal parts of disagreement on value and agreement on price.
If you’re new to our Quantitative Gravity framework, it’s important to note that the four quantitative dimensions of a market that we monitor typically move ahead of price. Said another way, price is the last aspect of a financial market to move, quantitatively speaking.
However, price is an important factor, and my bearish thesis for U.S. industrial equities will remain intact as long as XLI trades below $77.31.
The Quantitative Gravity bottom line is that all four aspects of XLI’s underlying market structure are indicating that despite the recent rally, XLI is a prime short candidate.
Behavioral Gravity says what?
Our Behavioral Gravity lets us evaluate investors’ perception of this market and how that perception is changing as we move through time.
Retail investors have added approximately $100MM to XLI so far this year, but it has experienced massive outflows over the last few weeks. Investors are using this latest rally as an opportunity to get out. However, short interest has remained fairly stable over the last few months. This tells me that people are booking profits, but blissfully unaware of how bearish the current Fundamental Gravity is for XLI.
The Behavioral Gravity bottom line is that investors may not be bullish anymore, but they still aren’t bearish enough. I love shorting a market before it becomes a consensus bear.
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