Divergence across sectors hard to ignore
Equity and other markets review 7.11-12.11.2022
General overview: For some time now, I have been having a strange feeling about the market. My gut would tell me that both sentiment and price action have been very bullish recently, including last week. Yet when I look at the charts, facts make the story much less clear.
I see a drop in SPX of more than 3% last week, textbook rejection of the sma100 on the daily level in the 3900-3950 area and price currently residing below key resistance at 3800.
Furthermore, the only thing Powell made clear AGAIN last week during his speech, is that he does not want the market to go bananas on the upside. As some astute FED readers noted, there was something for everyone in the speech. Those that wanted to hear the dovish rhetoric, liked the part where he was communicating the future slow down of the pace of hikes, and those that are hawkish resonated well with the higher terminal rate saying. At the end of the day, the market took it on the chin that day and the Eurodollar futures continued going lower, another counter argument to my gut feel.
But what about that bullish feeling? Every trader values and hones his/her intuition, which is without a doubt one of the most valuable things a trader has in his toolkit. And having this feeling should not come out of thin air at the end of the day. When I try to reverse engineer and see where this ‘intuition’ comes form, I can easily pin point a number of instances that contributed to it, most of which I recently tweeted out.
And the way the dollar has been trading definitely adds to that feeling.
All of this leaves me with in a tough place - how do I reconcile my guts with the facts? So far we have been right to take profits in the 3900 area and not to get astray from the current environment looking for an outsized profit. This is not the year where you try to pick bottom and aim for the stars. And technically, the current price is somewhat in the middle of nowhere, between 3700 and 3800 with this week having midterm elections’ results and CPI data. It appears to me that there is no rush to pick a side now and best thing for one to do is wait.
Sector overview and potential trades: Here things become more interesting. I have noticed that some sectors closed on Friday at levels that spark a huge divergence with the overall indices. Real economy sectors such as XLI (industrials), XLB (materials), XME (metals and mining) took the China reopening theme very close to heart and were bid up like there is no tomorrow.
I am leaving energy out here for a purpose, as its strength has been obvious from the beginning of the year. However, those above and especially XLI and XLB are now trading above key moving averages. Their relative strength has its nice fundamental reasoning not only with China secretly loosening its choke on the economy but also with Powell’s soon-to-slow-down-pace-of-hikes talks. The latter would leave real economy sectors doing fine in case of a mild recession. If we add to that their asset heavy balance sheets which supposedly would benefit from inflation, the case for a mid-long term bid seems solid.
On the complete opposite side reside the tech names XLF, IGV. Powell’s talk got them crushed and Friday’s bid did not help much either. They are now trading dangerously close to their lows. It is not only the mega caps that are suffering but also the speculative ARKK names. Higher terminal rate is a huge headwind for unprofitable businesses or for those with bloated valuations. I strongly suggest one to look at those more as a potential short on bounces than to get long. All the talk about megas being ‘dirt cheap’ and WSB squeezes is to be put in the basement for now. To be completely transparent, I do think they might provide some short-term contrarian swings and might try them out but I realize I will be pissing against the wind.
Current positions: I am currently long DE (half risk) and EWZ (full risk).
My long DE is well hedged. I got long call spread for Nov with strikes $390-400 against which I have shorted a Nov 11 $405-415 call spread to get some extra juice out of the trade. As previously mentioned, I do like XLI here and having a ticker that has shown strength makes total sense to me.
I am also long Brazil through EWZ. Last week I noted that I might jump on the trade and why and if missed it, you might want to check it out here. I really loved how the ‘worse’ election outcome (Lula winning) met strong bidding with volume. That was a clear sign for me to get long and so I did with a mix of Dec 34$ calls and $34-36 call spreads. Lucky I was with the explosion in bidding on Friday to turn my naked calls into call calendar spread by shorting Nov 11 36$ calls against it. Brazil is very rich on commodities, has high nominal and real interest rates, huge positive inflows lately and with dollar topping in the short term, might turn out to be a great setup for a long trade (or even investment for those who are into it).
Conclusion: I find myself more bullish than the facts suggests. I value my intuition more than anything but with key events such as Midterm election results and CPI data coming this week and overall indices in a somewhat choppy area I believe best thing to do is wait for some clarity on direction. While SPX is choppy, under the surface there appears to be a strong divergence between real economy sectors and tech that is now hard to ignore. When the time comes, I want to get long strength and short weakness. We are trading in a market where appropriate stock selection gets increasingly more valuable.