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Zen Master Says Long US Tech (XLK) and Short US Energy (XLE)

01/18/2018 1:14 pm EST

Focus: ETFS

Landon Whaley

Editor, Gravitational Edge

Trade ideas: If inflation begins to slow while U.S. growth continues to accelerate, then being long U.S. technology and out/short U.S. energy stocks will be a profitable way to roll, writes Landon Whaley of Focus Market Trader Thursday.

“An animal will jump at every sound, a leaf in the wind, a falling cone. A disciplined man will move only when it is necessary … the moment before it is necessary.” This is one of my favorite quotes from The Ronin, a book loosely based on an ancient samurai legend told to the author, William Dale Jennings, by a Zen Master.

The Zen Master nailed the difference between what is required to be a successful investor and how most investors behave.

As we start the new year, investors continue to jump at the latest “leaf in the wind,” whether it’s the ongoing cryptocurrency bubble, the rumor that China is wavering on U.S. Treasuries or the much-maligned melt-up in U.S. equities.

While these stories make for good clickbait and viewer eyeballs, they are nothing more than falling cones. Being disciplined is the only way to consistently see risks and opportunities that twitchy investors miss because they jump at every sound.

Discipline is telling me that there is currently just such an opportunity in U.S. energy and technology stocks.

Fundamental Gravity says what?

The trajectory of both growth and inflation is critical to understanding the risk and reward of asset classes that are being traded in an economy.

On the growth side of the economic equation, the U.S. has been enjoying a growth-accelerating regime since the summer 2016. Despite being four months older than the average “growth up” period, there are no signs it’s near an end.

In fact, my real-time market indices, built to track the direction of U.S. growth, are signaling that growth is continuing to accelerate here in 2018. My high-growth index, composed of assets that perform well when U.S. growth is accelerating, has gained 5.1% this year and is outperforming my slow-growth index by 730 basis points!

On the inflation side of the equation, everyone and their mother believes that the six-month upward trend will continue through Q1 2018. People are so bullish on U.S. inflation that expectations for the next one, two and three years are at the highest levels in five years.

To all those inflation bulls, let me channel my inner Lee Corso: “Not so fast, my friend!”

This crowd’s primary belief is that higher oil prices will perpetuate the recent move to higher inflation. Unfortunately for them, the data indicates that this conclusion should be far from foregone.

The last time crude traded at $64 was December 2014, when inflation was running at a +0.7% annual rate. Even when oil was trading around $100, U.S. inflation never breached the 2.1% level, which is where U.S. CPI is currently sitting. Suffice to say, inflation is driven by more than just the price of oil.

That’s not the only chink in the bullish inflation story. The other is that the year-over-year comparisons for inflationary readings are about to get really difficult to start 2018.

When inflation hit 2.5% and 2.8% in January and February 2017, it did so against much lower inflation rates of just 1.4% and 1.0% a year earlier, in January and February 2016, respectively.

The inflation readings for this month and next month will be measured against those rates from a year ago, which were multi-year highs. This means we are likely to see a sequential slowdown in inflation for the next few months.

When this sequential slowing occurs, investors are going to be quick to re-evaluate their “up, up and away” view on inflation. This consensus view tells me that even a minor downward shift in inflation expectations could have a profound impact on the prices of reflationary assets, such as energy stocks.

If inflation begins to slow while U.S. growth continues to accelerate, then being long U.S. technology and out/short U.S. energy stocks will be a profitable way to roll.

Quantitative Gravity says what?

Quantitatively, when U.S. growth accelerates as inflation slows, it’s bullish for U.S. technology stocks and bearish for U.S. energy stocks.


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Between 2009 and 2017, the U.S. experienced three separate phases when its growth accelerated while inflation was slowing, each lasting approximately six months.

During these regimes, the Technology Select Sector SPDR ETF (XLK) performed well, averaging a +10.4% return, while experiencing an average drawdown of −7%.

On the flipside, the Energy Select Sector SPDR ETF (XLE) averaged a −3.1% decline and experienced an average drawdown of −14%.

The most recent “growth up, inflation down” U.S. economic phase occurred from February to June 2017. During that four-month stretch, XLK gained 5.4% with a −4.4% drawdown, versus XLE’s −7.9% loss and −11% drawdown.

Behind door one we have an asset class that has 1300 basis points more performance with half as much downside risk than the asset class behind door two. Which door do you choose?

Behavioral Gravity says what?
Behaviorally, two of the four largest technology stock exchange-traded funds have seen net outflows this year, while the remaining two have added under $100MM in new assets. This lethargically bullish view of U.S. technology stocks is also apparent in the Nasdaq 100.

The Powershares QQQ Trust ETF (QQQ) has seen outflows in 2018, and investors in Nasdaq futures are sitting with one of the lowest levels of long exposure in the last three years.

In contrast, investors have been flocking to U.S. energy stocks like moths to a flame. They’ve added over $1B to the four largest energy equity exchange-traded funds in just the last two weeks; $800MM of those inflows went to XLE.

For obvious reasons, crude oil is highly correlated with energy stocks. Investors in crude futures are doing their best Sir Mix-a-Lot impersonation by being as long, strong and bullish on oil as at any time in the last three years.

Investors are shunning technology and betting heavily on higher inflation through reflation assets, like energy stocks.

The bottom line

The mild and disinterested bullish view on U.S. technology stocks juxtaposed with uber-bullish positioning in reflation assets is setting us up for a very nice, non-consensus trade of being long U.S. technology stocks against a short U.S. energy stock position.

The risk and reward data for these sectors in a “growth up, inflation down” economic regime is like Shakira’s hips: it doesn’t lie. The risk-reward stakes are heavily skewed in favor of being long U.S. technology stocks, and the decidedly bearish Quantitative Gravity of energy stocks during these regimes makes that sector an excellent short candidate.

Don’t be an investor who jumps at every leaf in the wind and every falling cone. Be disciplined and remain data dependent, process driven and risk-conscious.

The long trade idea

As long as XLK trades above $63.20, then new long trade ideas can be initiated on declines to $66.02, or lower. Depending on where you enter the trade and how much room to move you want to give this trade, you can use a risk price between $64.68 and $63.20.

Your risk price line in the sand is $63.20, if XLK touches that price, even for a second, then you should exit any open trades.

If the trade moves in your favor, you can book profits on some, or all, of your position on a rally to $68.27, or higher.

The short trade idea

As long as XLE trades below $80.55, then new short trade ideas can be initiated on rallies to $75.54, or higher. Depending on how much room you want this trade idea to move, use a risk price between $76.42 and $80.55.

Your risk price line in the sand is $80.55, if XLE touches that price, even for a second, then you should exit any open trades.

If the trade moves in your favor, you can book profits on some, or all, of your position on a decline to $73.95, or lower.

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