How to Use Fundamentals to Trade XLF, XLK and XLU

05/10/2017 2:46 am EST


Landon Whaley

Editor, Gravitational Edge

When the slowdown occurs, avoid growth sectors like financials and technology, and shift your portfolio towards bonds and their equity cousins, asserts Landon Whaley, Founder and CEO of Whaley Capital Group.

Tim Duncan retired last year after 19 seasons as a forward for the San Antonio Spurs. His nickname was “The Big Fundamental.” As nicknames go, it leaves a lot to be desired, but frankly it describes his game to a T. The guy played sound, fundamental basketball, which is considered boring in this world of SportsCenter highlights. Yet his career performance was the stuff of legends.

He retired with five championship rings, three Finals MVPs and two regular season MVPs, and as arguably the greatest power forward of all time. In addition, Forbes estimates he added about $300MM in value to the San Antonio franchise. Talk about a 19-year bull market!

When it comes to trading markets, it’s the Fundamental Gravity of a market that matters most. It’s not as much fun as perusing price charts, watching for abandoned baby candlestick patterns or those Fibonacci levels that the Illuminati love so much. And it’s certainly not as entertaining as watching gas bags talk about stocks while pushing buttons on a sound machine. Booyah!

But I can promise you this: nothing in this world, outside of central bank policy, has more impact on the direction of US asset prices than the trajectory of growth and inflation in the US economy. Nothing.

Bonds are riskier than Silicon Valley

US growth has been accelerating over the last three quarters and counting. Over this time frame, the winning playbook has been to be long high-growth sectors like financials and technology.

Since June 30, 2016, the S&P 500 is up 16.2%, which is an astronomical nine-month return.

But to put it in perspective, US financials, via the Financial Select Sector SPDR (XLF), are up 30.0%, and the US technology sector, via the Technology Select Sector SPDR (XLK), is up 28.9%.

The sectors you wanted to avoid over that time frame were bonds and their equity cousins, like utilities. Since last June, utilities, via the Utilities Select Sector SPDR (XLU), have returned just 1.1%, while long-dated US Treasuries, via iShares Barclays 20+ Year Treasury Bond (TLT), have declined 11.2%.

Understanding the Fundamental Gravity and shifting your portfolio accordingly is not just about earning the best returns. It’s most importantly about managing risk.

In the current period of accelerating growth, the S&P 500 has experienced a maximum (peak-to-trough) drawdown of just -4.3%. XLF and XLK have experienced similar drawdowns, of -8.9% and -4.1% respectively. Technology stocks have delivered nearly double the return of the S&P with slightly less downside risk.

Contrast this with the downside risk experienced by people invested in bonds and their equity cousins for the past ten months. Utilities (XLU) has fallen by as much as 12.4%, and TLT has experienced a maximum drawdown of 17.8%. That’s almost an outright crash!

Think about the implications of what we’ve just discussed.

Your grandpa’s T-bond has had over four times as much downside as a collection of Silicon Valley’s finest publicly traded companies.

Not only have technology stocks had a quarter of the downside of US Treasuries over the last nine months, they have also delivered 38% more return!

It’s not just about knowing where to be positioned and what to avoid when growth is accelerating. It’s equally important to position your portfolio appropriately once US growth begins to slow again.

Slow growth playbook

Markets and economies are cyclical, they don’t go straight up or straight down. This means that at some point, possibly in the second half of this year, the pace of US economic growth will begin to slow.

When this slowdown occurs, the playbook for trading US markets is going to shift markedly.

You’re going to avoid the growth sectors like financials and technology, and shift your portfolio towards bonds and their equity cousins.

The risk and return stats from the last economic slowdown, from Q1 2015 to Q2 2016, prove why this is the “slow growth” playbook.

Over those 15 months, the S&P gained 2.5% and experienced a 13% drawdown. US Financials (XLF) declined 2.6%, but at one point during that stretch was down as much as 23%. Ouch! Technology stocks (XLK) gained 6% with a 14% drawdown.

Bonds and their equity cousins easily outperformed both the S&P 500 and the growth sectors, with less downside. Utilities (XLU) gained 22% with an 11% downside, and long-dated Treasuries gained 8% while experiencing a 10% pullback.

While technology stocks outperformed the S&P, they lagged significantly behind both utilities and US Treasuries, and delivered more risk.

The risk contrast is not as dramatic as during high growth periods, but it is still significant—that is, assuming you consider the potential to at least triple the S&P’s return with less risk to be significant.

The bottom line

The importance of a market’s Fundamental Gravity is the same as the tide in sailing. You can sail for a while paying attention only to the wind, which in trading parlance is the price action of a given market. But if you don’t understand the tide, which represents the market’s Fundamental Gravity, you eventually crash into the rocks. Understanding the tide is not only the key to avoiding the rocks, it’s also the key to earning outsized returns while dramatically reducing your risk.

Until next time, stay data dependent, process driven and risk conscious, my friends.

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