It’s really easy, with the ever-expanding universe of information sources, to miss the forest for the trees.
It's easy to feel like you need to make a change in your portfolio every time you hear market pundits talk about each data point as if it’s the most critical data point in the history of earth.
The problem with that strategy is that you would change your portfolio 9 times a day. Oh, and every data point issued by the government is not, in fact, the most critical data point in the history of Earth.
And now, you can add the daily speculation as to when, how or if the Fed will raise rates this year, next year or not at all.
It’s all about growth baby, the rest is just small talk. Short-term price movements are based on crowd psychology and technical factors. But the farther out from today you go, the more markets move towards their underlying fundamentals.
For equity markets, this means they move towards the expected growth of the underlying economy they represent. Period.
Easy Trade For Today's Growth
The Big Question remains: Is the US growing or slowing?
US data has been slowing at the margins for several months now. But US annual GDP growth rate has been slowing since Q3 2014.
Most professional asset managers are well positioned for when growth is accelerating but do poorly when growth is slowing.
I’m going to show you a very a simple trade that can capitalize on a slowing US economy.
Let’s look at what the type of US growth different segments of the capital markets are telling us to expect. Investors began the year by positioning themselves for higher US growth.
US yields climbed for the first 6 months of the year as investors rotated out of bonds. The US dollar started the year off strong before peaking back in March. And from a US sector perspective, technology outperformed the broader US equity market by over 200 basis points before peaking back in July. Since the summer, its been a different story all together.
My “Slow US Growth” market index has handily outperformed both the broader US equity markets as well as my “High US Growth” market index. This relative and absolute out performance has been consistent since the Summer, minus a couple of weeks at the end of August.
Good Money In Slow Growth
That said, the first couple of weeks of Q4 has seen the positioning in certain asset classes have begin to shift. High growth assets are once again beginning to outperform both slow growth assets and the broader US equity market.
However, given the onslaught of data that continues to show that US and global growth is clearly sliding, I think this shift is transitory and is providing us with an opportunity to position ourselves for slower growth ahead.
So, while investors' conclusions and markets jumped all over the place last week, I didn’t see a lot in the data to get worked up about. In addition, markets are continuing to jockey back and forth without any real clear direction. My takeaway from last week is that markets are still questioning how to be positioned for the final 3 months of 2015.
As always, data is only useful when it's put in the context of the broader markets. The strongest periods of economic growth for the US have always been accompanied by the trifecta of strong equity markets, a strong US dollar and rising/elevated interest rates.
So far this year that trifecta is mixed: S&P 500 (SPY) is down slightly at 0.6%%, US dollar (UUP) is up 3.3% and US yields have declined 3.3%. But as usual, these top line performance numbers don’t tell the whole story.
Currency markets are by far the “smartest” markets and this fact was proven out this year. While the S&P and US yields clocked higher all year until peaking during the Summer, the USD peaked in early March and has been in a sustained downtrend ever since.
So we now have both the USD, US yields and US equities in at least 4-month downtrends.
The downtrend in these markets is mirroring US economic data.
On the heels of China, Japan and the Euozone’s latest round of service PMI reports, last week we got the latest US Services PMI report. The report showed further slowing at the margins.
Despite remaining in expansion territory, this report peaked back in March and has been decelerating ever since. Downtrend.
I could rattle off a whole list of US economic indicators that look fine if you look at the top line but the trends are headed in the wrong direction. Couple that with absolutely no positive news from other countries around the world and the IMF cutting growth forecasts again last week for the 4th time in the last year. All of this means it will be difficult for the US growth to accelerate higher during the final quarter of the year no matter where Q3 GDP finally sits.
The Long and Short Of It
The trade to favor is one of slow growth assets over high growth assets. A simple trade to put on is simply a long US utilities (XLU) versus a short US technology (XLK) trade. You can certainly use individual stocks if you prefer, but I like the easy of using macro vehicles like sector ETFs for a trade like this one. Historically, when US growth is slowing, utilities outperform technology companies by a healthy margin.
Since US GDP growth peaked last year, utilities have outperformed technology by 400 basis points and the broader market by 600 basis points. Since the Fed’s no-rate-hike decision in September, utilities have outperformed technology by 300 basis points and the broader market by 400 basis points.
These are not insignificant margins and if you structure the trade to balance the respective volatility levels of the instruments involved, the basis points of out performance can be turned into essentially risk-free rates of return.
Watch XLU to determine if this trade is going to continue to work or not. Specifically, watch how XLU trades when it reaches the $44.65 to $45.00 area. If XLU is able to close above this level for 3 consecutive days, then this trade is going to have a lot of room to run. Likewise, if XLU is unable to breach that level, then the expectations for US growth may have improved and this trade is going to be limited.
That said, it's important to bear in mind there are potential regime shifts all over the place; pick your spots even more cautiously than you do normally and trade with smaller sizes than you would normally.
The beauty for us is that it doesn’t matter if the US enjoys high growth or if economic growth slows from here because we will continue to focus on the critical economic and market indicators so that we can position ourselves to take advantage of the opportunities that present themselves, regardless of what's happening.