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Trade Idea: Humanness and a Shorting Opportunity for Semiconductors

06/20/2018 3:00 pm EST

Focus: STOCKS

Landon Whaley

Editor, Gravitational Edge

“Humanness” is a word I use regularly to sum up all of the biases, emotions, and hardwiring that make human beings innately flawed decision-makers. The only reason financial markets have risks (and opportunities) is they are comprised of humans making human mistakes.

Last week, the world’s most impactful central bankers were in the spotlight, reminding us that they too are only human, and their humanness continues to provide us with both risks and opportunities.

The Fed raised rates, the Bank of Japan announced a slight pushback from the easing bar, and the European Central Bank (ECB) whispered its own hawkish dirty talk in our collective ears. But there is just one problem: global growth is slowing.

When central banks tighten monetary conditions against an economic backdrop of growth slowing, it causes recessions. Period. That economic equation is as scientifically valid as E = mc2.

In December 2015, the Fed raised rates into a slowing U.S. economy and caused an industrial recession during the first half of 2016. The People’s Bank of China did it in Q1 of this year, and the Shanghai Composite is now off 15% from its late January high and headed quickly towards crashville.

The ECB is the poster child for the fact that central bankers are not immune to humanness.

On the one hand, ECB President Mario Draghi reiterated that the ECB’s asset purchase program will end in December, as expected.

On the other hand, the ECB revised and lowered their expectations for 2018 growth based on the growth slowing data I’ve been discussing for the past six months. The ECB is knowingly tightening monetary policy in the midst of economic growth slowing. If that isn’t a prime example of humanness, then I don’t know what is.

We’ve seen this movie before, and it ends poorly for equities and other risk assets trading in those economies where the central banker in charge exposes his humanness to the entire world. This time will be no different, so position yourselves accordingly.

The current playbook for anything outside the U.S. is to be short or out entirely—there is simply no middle ground. Given the global Fundamental Gravity, there isn’t an equity market (or currency) on earth I’d be long right now outside the U.S. If you’re a long-only investor, you would ideally be completely U.S.-centric for the time being. However, for those of you mandated to have international exposure, I’d limit it to developed nations and the lowest level of exposure your mandates allow.

In the Asset Allocation Model, we will continue to pound away on the short side of German, South Korean, Brazilian, and Chinese equities as those markets bounce to lower highs. We will also continue to take opportunistic shorts in copper.

The playbook inside the U.S. remains the same: selectively attack the tech and consumer discretionary sectors but keep your head on a swivel and maintain short leashes on those positions as we enter the back half of 2018. At the same time, begin to initiate positions in those asset classes and equity sectors that will outperform when the growth that is slowing globally finally reaches our shores.

We will get long tech and consumer discretionary in the Asset Allocation Model if a buyable pullback materializes. We will also initiate (and risk manage) positions in utilities, staples, gold-related assets, and possibly even government bonds as we creep closer to Q4 of 2018. On the short side, we will concentrate on industrials and wait for the market to give us the all-clear signal to go after financials.

On May 28, we rolled out our “The Other Korea” macro theme and ended that week’s Coddiwomple by saying, “In the weeks ahead, when the timing is right, we will use this same theme to short a key U.S. industry that has been on an absolute tear for the last two years.” Well, wait no more, because the timing is right to unveil that U.S. sector and discuss why it’s setting up for a bearish fall from grace.

NZT 48 for “The Other Korea”

This week, our smart pill explains why the current macro environment is conducive to being short the VanEck Vectors Semiconductor ETF (SMH).

The Fundamental Gravity bottom line is that the combo platter of slowing Asian economies with an impending U.S. economy slowdown is going to induce a semiconductor bear market.

The Quantitative Gravity bottom line is that while SMH’s readings are still bullishly inclined, they are deteriorating at the margin. All bear markets start out as a bull market that first gets less bullish and then enters a bear market.

The Behavioral Gravity bottom line is that investors are starting to turn bearish on SMH and vote with their feet. Luckily for us, SMH’s price is still hovering near 2018 highs, which means there’s plenty of downside from here and room for people to get even more bearish once SMH’s price has capitulated to the downside.

We share detailed entry and exit guidelines with our research clients including specific price targets for risk and profit taking. In addition, we send out real-time alerts whenever we initiate or close a position in our Asset Allocation model.

If you’d like to receive the details for this short SMH trade and be notified when we are initiating the position, please email us at ClientServices@whaleyglobalresearch.com. We will also provide you with a free eight-week trial of our research offering, which consists of two weekly reports: Gravitational Edge and The 358.

Fundamental Gravity says what?

Two chief variables impact the risk and return of asset prices: economic conditions and how central banks respond to those conditions. Together, these variables drive what we call an economy’s Fundamental Gravity.

Multiple aspects of the South Korean economy are showing signs of deterioration. This is a critical development because historically, South Korea has been a reliable bellwether for global demand and growth. This latest string of economic data speaks volumes about the bearish trajectory of South Korea, but it’s also a read-through on the trajectory of the global economy. Keep in mind that South Korea is not alone—export growth in Taiwan, Indonesia, and Thailand has also slowed since peaking in December.

Fundamentally, the semiconductor industry has been showing its own brand of growth slowing. The annual growth rate of global semiconductor billings has been slowing since December and is now sitting at 12-month lows. Couple this fact and the deterioration across the Asian emerging economies with a coming shift in the U.S. Fundamental Gravity to a growth slowing environment, and you have all the makings for a bear market in the U.S. semiconductor industry.

For the last two years, the VanEck Vectors Semiconductor ETF (SMH) has been on an absolute tear. Since U.S. economic growth bottomed in June 2016, SMH has gained a whopping 97.1%! The risk and return of SMH is drastically different when growth is accelerating than when it’s slowing. In high growth environments, SMH averages a 3.2% quarterly return, with an average drawdown of just 10.1%. However, when the U.S. economy begins to cool, SMH typically averages a -3.4% quarterly return and a peak-to-trough drawdown of 18.3%.

That’s the power of the Fundamental Gravity, folks.

Given that SMH has doubled in price in just 24 months, we think those historical averages are skewed even more to the downside.

The Fundamental Gravity bottom line is that the combo platter of slowing Asian economies with the impending U.S. economy slowdown is going to induce a semiconductor bear market.

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 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). SMH’s Social reading indicates it’s taking a breather from party mode. Remember, markets don’t go straight up or down. The tech space has been on an absolute tear, and only time will tell if this is just a pullback before heading higher, or if we’ve seen the 2018 top in SMH. 

Momo is our measure of the amount of force behind the market’s current state. SMH’s Momo is losing its bullish strength for the first time since May 9. Again, caution is warranted, as this could just be a momentary reduction in force before the next bullish thrust higher.  

Barometric is our measure of the rate of force behind the current Momo. SMH’s Barometric tells us that buyers are still in control of this market, but their strength is beginning to wane.

Topo, which measures the probability of a drawdown, is indicating that the drawdown risk for SMH over the over the next 10 trading days is beginning to rise. At the margin, this is a bearish development.

All aspects of SMH’s QG are still registering bullish readings, but those readings are less bullish than just two weeks ago. Remember, we focus on what’s happening with the slopes (or trend) in financial market data. All bear markets first begin with a market’s QG becoming less bullish. The key to successfully trading a bear market is to position yourself while the market is still transitioning from bull to bear, rather than waiting for the bear to come out of hibernation.

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. In other words, 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. semiconductor equities will remain intact, as long as SMH trades below $115.08.

The Quantitative Gravity bottom line is that while SMH’s readings are still bullishly inclined, they are deteriorating at the margin. All bear markets start as a bull market that gets less bullish first and then enters a bear market.

Behavioral Gravity says what?

Behavioral Gravity allows us to evaluate investors’ perception of this market and how that perception changes and shifts over time.

So far in 2018, retail investors have added approximately $111MM in net new funds to SMH. However, they’ve yanked approximately $125MM from SMH in just the last 10 trading days. This outflow equals approximately 8% of the entire asset base of SMH, which is yuge! 

The Behavioral Gravity bottom line is that investors are starting to turn bearish on SMH and vote with their feet. Luckily for us, SMH’s price is still hovering near 2018 highs, which means there’s plenty of downside from here and room for people to get even more bearish once SMH’s price has capitulated to the downside.

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