This week, boys and girls, we’re going to discuss “lower highs” and what they mean for the second half of 2018. We are seeing lower highs in a number of critical markets, but none are more important than that of crude oil and U.S. 10-year yields, writes Landon Whaley.
First, black gold made a lower high for the first time in over 12 months on May 30 and a second on June 14. Crude almost made a third last week but was saved by Friday’s OPEC-related headline risk.
But why is this series of lower highs important?
Crude oil’s year-over-year price change has historically been a great indicator of the future trajectory of growth. In fact, the annual momentum of oil has a better prognosticator track record than everyone’s favorite, Dr. Copper. This historically accurate growth indicator has slowed every trading day since the June 14 lower high. This conversation will be moot if crude breaks above $69.48 for three consecutive trading days, however, it bears monitoring.
Crude isn’t the only market signaling for weaker growth ahead, as 10-year yields are singing the same tune. U.S. 10-year yields hit a 7-year high of 3.115% on May 17, immediately fell 35 basis points, and managed a lackluster rally to a lower high of 3.009% on June 13 before heading south again. Similar to crude, the lower high made by 10-year yields is the first of its kind in over a year.
With crude and 10-year-yields, I haven’t just cherry-picked a couple of markets to make my point. U.S. equities are painting a similar picture that U.S. growth is about to take the slow growth boat to China. A number of U.S. sectors are recording lower highs, including energy, basic materials, industrials, and financials. And U.S. sectors that typically outperform in a growth slowing environment are finding their footing and starting to gain some bullish traction, including utilities, consumer staples, and health care.
Let me be clear: this is a developing growth slowing picture, not one that is completely filled out. The baton from growth accelerating to growth slowing is in the process of being passed, but the handoff may not be a clean one.
The playbook in 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. We will also consider shorting energy-related equities if crude oil can’t break out above $69.48, or if it breaks down below $64.28 along with a deteriorating Quantitative Gravity.
In this week’s macro theme, we discuss “U.S. shift work,” which is based on U.S. growth slowing.
Am I early? Probably. I usually am. I like to get to the party a little early, stake out the best vantage point, and get acclimatized to my surroundings before things get into full swing. This philosophy means I spend some time standing alone and looking awkward. However, awkwardness and solitude are rewarded because being early provides two distinct advantages.
First, I’m able to survey the best spot to position myself for maximum social interaction, where people are naturally likely to gravitate. I position myself in the markets most likely to outperform before other investors even arrive. Second, I’m able to chat up the bartender, Steve, while he sets up the bar. My first-name-basis rapport guarantees my bourbon pours are a little heavier than my fellow partygoers. You might say my evening has a better reward-to-risk setup than that of investors who arrive fashionably late.
NZT 48 for “U.S. shift work”
This week, our smart pill explains why the macro environment is becoming conducive to being long the Consumer Staples Select SPDR ETF (XLP).
The Fundamental Gravity bottom line is that when U.S. growth slows, consumer staples is one of the few equity sectors that outperforms on a relative basis in terms of both return and lower drawdown risk. The Quantitative Gravity bottom line is that all four quantitative aspects are decidedly bullish, and all we need to get this consumer staples party started is a buyable pullback. The Behavioral Gravity bottom line is that investors are bearish on XLP because they believe the high growth train we’ve been on for the last two years is still a long way from its destination. Those of us who are data-dependent know that the train is still chugging along, but we are very close to the station.
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 long XLP 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 three weekly reports: Gravitational Edge, The 358, and The Weekender.
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.
The “lower highs” market data we covered in this week’s Coddiwomple indicates that this macro theme may already be active. We haven’t seen a ton of growth slowing in the recent economic data to confirm what markets are saying, but that isn’t surprising.
Financial markets often front run changes in an economy’s Fundamental Gravity. The natural progression as an economy shifts from one Fundamental Gravity posture to another is for there to first be a shift in the risk and return profile of asset classes, followed by a shift in the economic data.
That said, a few critical data sets have recently shown signs of deterioration. The manufacturing PMI for June slowed to a 7-month low, and June’s service PMI also slowed from the prior month. Industrial production growth flatlined for three consecutive months before slowing in May. Durable goods orders contracted in April and have now contracted in two of the first four months of the year.
We are the first to admit that one month of slowing data across a handful of indicators doesn’t indicate a Fundamental Gravity shift, but if we couple these economic developments with what markets are telling us in real-time, the growth slowing picture starts to fill out.
The Consumer Staples Select SPDR ETF (XLP) is currently trading exactly where it was in March 2016. XLP has gone absolutely nowhere, while experiencing a couple of mind-numbing drawdowns in excess of 15%. However, the risk and return of XLP is drastically different when growth is slowing than when it’s accelerating. In slow growth environments, XLP averages a 3.4% quarterly return with an average drawdown of just 5.7% and posts positive 3-month returns 71% of the time.
The Fundamental Gravity bottom line is that when U.S. growth slows, consumer staples is one of the few equity sectors that outperforms on a relative basis in terms of both return and lower drawdown risk.
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). XLP’s Social reading indicates it’s in party mode and getting ready for a long night out.
Momo is our measure of the amount of force behind the market’s current state. XLP’s Momo turned bullish on June 8 and has been building bullish strength ever since. The current Momo reading is also sitting at a bullish 7-month high.
Barometric is our measure of the rate of force behind the current Momo. XLP’s Barometric tells us that buyers gained control of this market on June 1 and have been building buying pressure ever since. In fact, Barometric is sitting at the most bullish reading since February 2017.
Topo, which measures the probability of a drawdown, is indicating that the drawdown risk for XLP over the over the next 10 trading days is extremely low.
All aspects of XLP’s QG are registering bullish readings and indicating more strength ahead. Couple this with the historical returns of XLP when growth is slowing, and you have a bullish combo platter of data.
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 bullish thesis for U.S. consumer staples will remain intact, as long as XLP trades above $48.39.
The Quantitative Gravity bottom line is that all four quantitative aspects are decidedly bullish, and all we need is a buyable pullback to get this consumer staples party started.
Behavioral Gravity says what?
Behavioral Gravity allows us to evaluate investors’ perception of this market and how that perception changes and shifts over time.
In just the last two months, retail investors have yanked approximately $664MM from XLP. This outflow equals approximately 8.3% of the entire asset base, which is yuge!
The Behavioral Gravity bottom line is that investors are bearish on XLP because they believe the high growth train we’ve been on for the last two years is still a long way from its destination. Those of us who are data-dependent know that the train is still chugging along, but we are very close to the station.
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