How to Trade Coming Twin Peaks for Growth and Inflation

03/23/2017 4:10 pm EST

Focus: STOCKS

Landon Whaley

Editor, Focus Market Trader

To sift through noise, Landon Whaley suggests analyzing three critical forces that influence asset prices: fundamental, quantitative and behavioral gravities. He is the Founder and CEO of Whaley Capital Group and publisher of The Whaley Report.

It’s easy in today’s world to get distracted by the latest investing narratives: the “animal spirits” in markets, markets being “offensively overvalued,” and historic low volatility being the harbinger of bad things. These topics are certainly the lifeblood of networks like CNBC, which are sitting at decade lows in viewership. But such media themes don’t actually move markets.

To help me sift through the never-ending noise in markets and discern signals that other investors miss, I rely on my Gravitational Framework. This framework analyzes the three most critical forces, or gravities, that influence asset prices: fundamental, quantitative, and behavioral.

Right now, this framework is signaling that both growth and inflation will peak and begin to decelerate in the next two months.

Growth is Accelerating, For Now
For months, I’ve been very bullish on the US economy and US equities because the US Fundamental Gravity has been bullish. This has been primarily driven by the fact that US economic growth has accelerated for eight straight months.

Based on key US economic indicators that I monitor, US GDP growth will hit around 2% in Q1. This represents a slight acceleration from the Q4 growth rate of 1.9%, and is a big reason financial and technology stocks are grinding higher with reckless abandon.

That said, eight consecutive months of improving growth have left a number of economic indicators at levels that indicate future weakness.

One such indicator, the Institute of Supply Management (ISM) Manufacturing Index, hit 57.7 in February after accelerating for six consecutive months. This is critical because whenever it has hit 57 or higher during the last 35 years, the US economy has slowed 100% of the time.

That’s one hell of a batting average, wouldn’t you say?

I’m not cherry-picking here; there are a number of other growth-related indicators hitting levels that typically herald a slowdown in growth.

Inflation is Ripping, For Now
On the inflation side, the same thing is occurring. Two inflation measurements, the CPI and the Producer Price Index (PPI), have reached levels that typically precede a tipping point in the data.

The latest CPI reading came in at 2.7%, which represents the top end of its trading range since the 2008 Great Recession. Historically, when the CPI crosses 2.0%, it generally pulls back for at least three months.

Similarly, February’s PPI reading was a scorching 2.2%. The last four times this indicator reached 2.0% or higher, it turned lower within two to three months.

This shift from growth and inflation rising together to a Fundamental Gravity of them both slowing will catch a ton of investors off guard. This is your opportunity to take advantage of a development that no one is talking about yet.

The Playbook
One of the best trades for a US economic environment characterized by slowing growth and inflation is to be short energy stocks via the Energy Select Sector SPDR, XLE. This sector of US equities is highly sensitive to adjustments in growth and inflation expectations.

Not only is the Fundamental Gravity turning bearish for US energy stocks, but quantitatively there is also a heavy weight around their feet. The recent breakdown in the crude oil price is a hugely bearish quantitative development. XLE has been positively correlated with crude oil 100% of the time over the last three years, meaning these two markets move in tandem. If crude oil remains in its current downtrend, it only adds fuel to our short XLE trade.

In the week ended March 17, XLE is trading at $70.00, and that’s the price to watch. Don’t chase this market lower! If you are an experienced short trader, you want to be in the habit of shorting strength. Initiate new short trade ideas above $70.00, but no higher than $73.40. Depending on your entry price, use a risk price between $70.40 and $73.40.

Your profit target on this trade should be down around the $63.00 area. If you initiate the trade around $70.00, then the maximum risk per share is $3.40 and the profit potential is approximately $7.00. That’s twice as much profit potential as possible risk.

If we get a favorable move and XLE closes below $63.00, then there is no support until $56.00. This dramatically improves the reward-to-risk ratio to $4 of profit for every $1 of risk.

The Bottom Line
The time to map a trading game plan is before economic factors shift, not after. When you are trading markets, the future is a range of probable outcomes and nothing more. If you can anticipate the most likely outcome and position yourself in trades that will outperform in that scenario, then you will be way ahead of most investors.

Remember, markets are more noise than signal. Staying data dependent, process driven and risk conscious will allow you to discern signals that other investors miss altogether.

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