XRT - Defensive Capitulation Warns Of Stock Market Correction Starting Mid-June

2023-06-02 11:49:44 ET

Summary

• The Utilities sector has been underperforming the broader market, with the XLU/SPY utterly collapsing the last three weeks.
• The defensive capitulation in the Utilities sector, combined with the overexposure to technology stocks, could lead to a risk-off environment in the stock market in June.
• The “market” is more than AI.

All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident. - Arthur Schopenhauer, Philosopher.

We all know Tech ( XLK ) and artificial intelligence ("AI") plays have been on fire, but make no mistake about it – this has been an incredibly narrow market. While everyone is focused on Nvidia Corporation ( NVDA ) (including me on Twitter, which candidly I’ve been having a lot of fun with), small-cap stocks ( IWM ) have performed poorly, consumer discretionary stocks ( XLY ) and retailers ( XRT ) look terrible, and bulls are becoming increasingly louder as headline averages confirm their biases.

And just as everyone seemingly screams we are in a new bull market and melt-up (which I alone loudly argued was coming starting October 3rd of last year), they now totally ignore the behavior of the most important sector of all – Utilities, as represented by Utilities Select Sector SPDR® Fund ETF (XLU).

Why in the world are Utilities more important than any other sector of the S&P 500 (SP500)? Because, as shown in the 2014 Dow Award-winning paper , “An Intermarket Approach to Beta Rotation,” their relative performance tends to warn of risk-off (high volatility regimes) in equities. This is quantitatively proven going back to 1926. Historically, when Utilities are outperforming, risk for stocks is heightened, and conditions favor an accident.

As shown in the chart below, the Utilities sector has been underperforming the broader market, with the XLU/SPY utterly collapsing the last three weeks.

As I noted in The Lead-Lag Report, this currently IS a risk-on signal on a relative momentum basis, but the speed with which defensiveness has utterly collapsed actually sets up for renewed relative strength in a couple of weeks.

The underperformance of the Utilities sector can be attributed to a number of factors, one of which is the growing interest in the technology sector. As the world continues to embrace AI technologies and other advances, investors have been piling money into the technology sector, seemingly at the exact wrong time. This enthusiasm for technology stocks has led to a rotation away from defensive sectors, such as Utilities and Consumer Staples ( XLP ), which are traditionally considered to be more stable and less susceptible to market fluctuations. As a result, these sectors have suffered, as investors chase the higher returns associated with technology stocks.

The defensive capitulation in the Utilities sector, combined with the overexposure to technology stocks, could lead to a risk-off environment in the stock market in June. This would entail a shift in investor sentiment, leading to a reduction in risk-taking and a return to more defensive sectors.

This is an incredibly important point. Investors screaming about the new bull market given market cap weighted averages are seemingly not realizing that we have never lived in an era where the percentage of the top 5 stocks actually makes the “diversified” S&P 500 ( SPY ) have more concentration risk than ever before.

We are in a seasonally weak period for stocks in May to October. We are still likely headed for a recession. And overconfidence is historically a precursor to breakdowns in equities. Yes - pre-election years are typically strong, and I believe the year ends up being a positive one, but as I always say, path matters more than predictions. Investors appear to be abandoning defensiveness just as defensiveness is about to start working because of a stock market correction to come. If I’m right, investors likely would suddenly switch back their exposure to high-risk assets, and the demand for safe-haven assets, such as government bonds and gold, may increase. This could result in a decline in the valuation of technology stocks, as well as other high-risk investments.

The underperformance of the Utilities sector and the increased focus on technology stocks could be a harbinger of a risk-off scenario in the stock market in June given the speed with which the move has occurred. Be careful of narratives. The “market” is more than AI.

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