S&P 500 and Russell 2000 at the upper end of their trend
“Risk on” is dominating price action with global equity prices near highs and yield curves steeper. The S&P 500 (SPY) and Russell 2000 (IWM) are near the upper end of their historical range suggesting limited upside in the near term.
Positive trend in Y/Y change of US 10Y2Y yield curve suggests a rebound in PMI
The surging equity prices stand in contrast to economic data which is still soft. The cynical interpretation is that assets have rallied without a fundamental reason. The more optimistic interpretation is that economic data will likely rebound over the next 2-3 months.
As an example in the above chart, the y/y change in US PMI and the y/y change in the 10Y2Y yield curve exhibits a tight correlation historically. The positive y/y change in the yield curve suggests that PMI will rebound as well. Investors shouldn’t expect a roaring rebound in PMI. Economic data tends to follow the maxim that a shallow decline leads to a small bounce.
Semiconductors ETF (SMH) at all time high
Other cyclical assets also suggest an economic rebound. The Semiconductor sector (represented by the SMH ETF in the chart above) is one of the most cyclically-sensitive sectors in the market. The 27% decline in late 2018 foreshadowed a slowing economy in 1H2019. However, the sector has recently made new highs. In addition to improving economic conditions, positive developments on trade negotiations between the US and China have propelled the sector higher.
China Tech (CQQQ) has lagged US Tech (QQQ)
One cyclical sector which has lagged is China Internet (CQQQ). Relative to US tech (QQQ) which is trading at all-time-highs, CQQQ has rebounded but is still below the 2017 high. Further progress on trade negotiations would help CQQQ to rally further. The election in 2020 is strong incentive for President Trump to reach a trade agreement in the next 6-12 months.
US E&P equities have decoupled recently from oil prices.
One sector that has lagged significantly is Energy, with the E&P ETF (XOP) trading near its low vs. S&P 500. This underperformance is even more unusual in the context of a revival in value stocks (Energy has significant value exposure), a timid rebound in cyclicals and a rising oil price. There are good reasons why the energy sector may lag in the long term going forward. However in the short term the sector is oversold vs. oil prices and may bounce back sharply.
A stabilizing force for oil prices is the upcoming Aramco IPO. This should incentivize the Saudis to limit downside moves in crude oil through rhetoric and potential actions through the OPEC+ cartel.
Additionally, value investors have started to pay attention to Energy companies. Warren Buffet and Carl Icahn certainly believe there’s value in Energy stocks; both investors bought significant stakes in Occidental Petroleum (OXY) this year.
Minimum Volatility ETF has record high AUM
In recent years, risk premia and factor strategies have gained in popularity with investors finding perceived safety in this new source of diversification.
A major beneficiary of these investment flows has been so-called low beta or low volatility strategies that bet on equities with lower market beta than indices or more cyclically-exposed stocks. AUM of the USMV ETF have doubled YTD in 2019 from $18B to $36B.
These equities often fall in the “fixed income proxy” category, with their higher dividend yields and lower volatility attractive to fixed income investors looking for more juice in their portfolios. Because of their perceived safety, the valuations have reached historical highs. That leaves them at the mercy of sharp drawdown, especially if growth accelerates and interest rates climb.
Minimum volatility ETF has further downside based on the previous divergence with US Treasuries
The Min Vol ETF has vastly outperformed other “safe” assets such as bonds. The relative performance of USMV and IEF have diverged significantly since the middle of 2018. The outperformance vs. other safe assets suggests further downside for this factor ETF which has been in vogue over the past 18 months.
Special thanks to Vinny B for contributing to this blog post.