The Whaley Report: This Time is Different


I’ve emerged from my tryptophan-induced coma and I’m coming out swinging. If I hear “this time is different” one more time, I’m going to do something crazy, like asking my in-laws to stay in town for another week.

I can’t even count the times I’ve heard media pundits and gurus say “this time is different” over the last couple of weeks. According to them, the U.S. dollar’s relationship to asset classes is no longer relevant, and the Holy Grail of investing, now that Trump is here to save the U.S. economy, is to get long the S&P 500.

As is usually the case, these guys are looking at one factor over one time period to draw conclusions. This type of lazy analysis highlights why it’s so critical to make decisions using a multi-factor process that evaluates various aspects of markets over multiple time frames. Let me state clearly that “this time” is not different.

In fact, the USD’s recent strength, coupled with the fundamental, quantitative, and behavioral gravities for the U.S. equity market, is offering up a risk-adjusted trade that could deliver a similar return to the S&P 500 over the next six months, but with none of the risk.

You can listen to the “this time is different” guys and blindly buy the S&P 500, or you can allow me to show you the benefits of being LONG the consumer staples sector via the Consumer Staples Select Sector SPDR ETF (XLP), while being SHORT the energy sector via Energy Select Sector SPDR ETF (XLE).

Don’t get me wrong; there are times to be LONG the S&P 500 in a directional trade. But most talking heads and money managers think that being LONG the S&P is always the answer. In my hedge fund, I do employ directional trades, but I also really like relative value trades. In a relative value trade, I get LONG one market and SHORT another market to extract the relative value of one of those markets over the other.

The overwhelming benefit to a relative value trade is that you can typically generate a return similar to an outright directional trade but with a much better risk profile.

Energy is Stretched

My perspective on the current state of the U.S. economy is well documented, so I won’t rehash that here. However, let’s dig into the corporation-level fundamentals, which are much more favorable for consumer staples than for energy.

The energy sector is trading at a forward price-to-earnings ratio that is three standard deviations above its 5-and 10-year averages, while consumer staples’ valuations are in line with long-term averages.

I don’t care what market or indicator I’m evaluating; any time something gets more than two standard deviations away from its long-run average, it piques my interest.

Whether the USD’s strength will hurt the profitability of U.S. corporations that earn a chunk of their revenue overseas is being hotly debated right now. But frankly, there is no debate, because simple math tells us that the greenback’s strength absolutely will squeeze the profitability of corporations that rely heavily on overseas revenue.

To that end, S&P energy companies derive half of their revenue internationally, while consumer staples have only 25% of their revenue stream exposed to international markets. All things being equal, a sustained USD rally will impact energy profitability substantially more than it will consumer staples.

Fundamentally, the LONG side of our trade idea, consumer staples, is in line with historical valuations, and has limited revenue risk if the greenback continues its ascent.

In contrast, the energy sector has valuations that are way out of whack at precisely the same time that a resurgence in the USD bull market is going to take a machete to part of the revenue stream. Sounds like a nice set up for a SHORT trade, doesn’t it?

U.S. Dollar Still Matters

Despite what pundits and gurus would have you believe, the U.S. dollar’s relationship to asset classes remains an extremely valuable quantitative factor in determining the future direction of asset prices.

At a base level, the U.S. dollar has historically had a positive relationship with consumer staples and a negative one with the energy sector. Right there, the USD’s continued strength is bullish for XLP and bearish for XLE. However, that’s just where things start.

The USD’s recent 6% gain in just two months has only happened on ten other occasions since 2000. When I analyzed how markets responded to those other USD rallies, I found something interesting.

In the six months after a big move in the USD, XLP gained nearly double the 4.1% average XLE return, achieving 7.6%. Not only that, but XLP posted a positive six-month return 100% of the time, while XLE was positive only 40% of the time.

Not only that, but the worst six-month return for XLP was still a positive 2%, while XLE’s worst return was a 15% decline.

Cash Drawdown

People’s trading behavior since summer, and especially since the election, is setting up this trade nicely, because XLE is extremely overbought and XLP has experienced an orderly pullback to critical levels of support.

Trump’s victory and the dramatic shift in inflation expectations has led to a record amount of cash being put to work in the last few weeks. Institutional asset managers dropped their cash position from 5.8% to 5% in just two weeks! This is the largest two week drop in cash since August 2009.

The energy sector has been a huge beneficiary of these fund flows. Investors have plowed $800MM into XLE since July, with a big chunk of that inflow coming since the election. This has left XLE trading at multi-year highs, but banging its head against significant levels of resistance.

On the flip side, investors have been yanking money from XLP like a bank run during the Shöwa Crisis. XLP has lost a fifth of its assets in just the last five months! These outflows have left XLP trading at price levels that are down from a year ago, but still very much in a bullish trajectory.

The Trade

If I haven’t convinced you, and you still want to buy the S&P, then given the massive rally in the U.S. Dollar over the last two months, your profit potential over the next six months is about 7%, with drawdown risk of about 15%.

This means that being LONG the S&P offers you twice as much downside as profit potential. Doesn’t that sound like fun!

This is where the benefit of a relative value trade becomes clearer.

Firstly, the profit potential is determined by looking at the expected return for each side of the trade in the context of the historical analysis I discussed earlier. XLP has an average six-month return of 7.6% and is positive 100% of the time, so the expectancy of being LONG XLP is 7.6% (7.6% X 100%).

On the SHORT side, XLE averages 4.1% but is only positive 40% of the time, which means the expected return of being LONG XLE is 1.6% (4.1% X 40%).

If both our LONG XLP and SHORT XLE positions deliver their expected returns, then we have a net gain of 6%.

That said, it’s the risk profile of this type of trade that brings it all home.

XLP’s worst drawdown over the last three years has been 10%, while XLE’s worst decline was 28%.

If these markets experience an average drawdown, then we still make money on our trade, because we may lose 10% on the LONG XLP side, but we’ll gain 28% on the SHORT XLE.

Great investors know that this time is never different, and not all returns are created equal. The only thing you’ll hear on shows like CNBC’s “The Quickest Way to Lose Money” “Fast Money” is about profit potential and upside. The problem for investors who make trades based on those shows is that superior returns are earned by applying a time-tested, multi-faceted process, which evaluates the risk of a trade first and the profit potential second. On one hand, going LONG the S&P gives you the opportunity to gain 7%, with twice as much downside. On the other, the XLP-XLE relative value trade gives you the opportunity to earn 6% or more, and protects the hell out of the downside.

Which one sounds better to you?

Symbols: XLE XLP

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