2023-11-08 04:22:22 ET
Summary
- The Fed's decision to pause its tightening cycle has sparked a bullish sentiment in the equity markets.
- Speculative institutions have been investing heavily in equities, particularly in the tech and consumer discretionary sectors.
- The SPDR S&P MidCap 400 ETF offers exposure to mid-cap equities and has a balanced weighting that may provide upside potential without sharp drawdowns.
Investment Briefing
The case for allocating to equities has ripened as of the last week and a half. For one, the Fed's decision to pause its tightening cycle has proven to be a bullish catalyst in the near term, presuming it is a temporary pause. Markets are a discounting mechanism. So it's not unreasonable to suspect it may be forecasting a period of better business into the coming years based on its response to the FOMC decision . Two, the economic data appears to have corroborated the Fed's view last week. Several economic indicators came in either ahead or behind expectations last week, both positives depending on what data stream is in question. The CPI print came in behind expectations at 3.7% YoY, industrial production was up 30bps, and U.S. unemployment lifted to 3.9%-all whilst GDP grew 4.9% from the prior quarter. In many instances, it was a case of "bad news is good news"-bad news, such as higher unemployment, lower production, etc.; translating to good news, in that this may signal the end of more critical data such as inflation and rate hikes.
And so the risk appetite has ignited a new flame with equity markets. A note from Goldman Sachs' (GS) prime brokerage this week stated that speculative institutions ploughed capital into equities last week at the fastest pace in nearly 2 years. According to a Reuters report on the note, '[s]peculators favored tech for long positions, including software companies. They were also bullish towards consumer discretionary companies like restaurants and fashion with products and services that people buy but don't need".
Asa result, equities at all points across the risk spectrum are worth a thoughtful analysis in my opinion. One potential instrument that lends investors' exposure to the mid-cap space is the SPDR S&P MidCap 400 ETF (MDY). The fund's objective is to invest in a broad selection of mid cap equities, and tracks S&P MidCap 400 Inde x as its benchmark. It has ~$18.1Bn in AUM and charges and expense ratio of 23bps on this amount. Dividends are paid quarterly at the rate of $5.93 in the last 12 months, currently yielding 1.3% at the time of writing.
Critically, the funds top 10 holdings only comprise 6.2% of the total weight, with most of the sector weighting concentrated in industrials at 21%, followed by consumer cyclical at c.15%. Technology has a 13% waiting in the portfolio which is still reasonable exposure in my opinion. Given the language on consumer discretionary and tech from earlier, this is constructive.
One of the benefits of such a balanced weighting, is that it provides the necessary equity exposure for the risk budget without the prospect of sharp drawdowns. This is particularly attractive in a newly trending market, where different participants will be battling for control of price and value. Moreover, there is debate on whether price is moving ahead of value at this point in time, or whether it is value that is leading price. So volatility isn't out of the question.
You can see this sentiment depicted in the image below, where in MDY has traded flat for the better part of two years, when it's market cap weighted counterparts have been sold off heavily. Only most recently have investors lifted the bid on these.
Figure 1. MDY long-term price evolution. Tracking sideways with marginal drawdown vs. market-cap weighted funds.
In that vein, my recommendations across all three investment horizons are the following:
Fundamental-
- Short term (coming, 12 months) - bullish ; The year-end rally following the Fed's November rate decision cannot be ignored. Speculative positioning is at a high point and driving capital flows. Equities-especially those in the mid to large cap domain-are paused to catch a bid. MDY still trades at 13.5x earnings, well below large cap peers, increasing the scope for capital appreciation in the coming year.
- Medium term (1-3 years) - bullish; In addition to the short term catalysts, Q3 earnings + projections were reasonably strong across sectors. Combined with U.S. GDP performance and forecasts, this is constructive for the next 3 years.
- Long-term (3 years+)- Bullish; Related to the mid term, U.S. equities still offer the most compelling upside potential in my opinion. I am bullish on equities in the long-term.
As a result, there is scope for allocating to mid caps via MDY in my view. I rate the fund a hold for the reasons discussed in this report.
Taking Points
- Bullish reversal looks underway in risk assets
Consilient observers of the market will have witnessed the sharp reversal of equity benchmarks in the last week as the Fed chose to pause its hiking cycle for the second meeting since July. The next questions are (i) is this the end of financial tightening, and (ii) can this rally extend? Economists at Brevan Howard made some interesting observations for the first point. Chief economist at the firm, Jason Cummins, wrote in The Financial Times that " [i]n the past, investors expected a Fed "put" with rate cuts from the Federal Reserve whenever threats to growth emerged. With inflation above target…the era of the Fed put is over".
As for the second question, a more thoughtful analysis is required. In my estimation, the following factors indicate a more constructive view on equities into FY'25:
- Q3 earnings were well above estimates in critical growth sectors such as tech and consumer discretionary (note: I've grouped communication services in tech here). I used the image below in a recent article , highlighting the positive outlook for U.S. earnings projections in the next 12-18 months. Analysis of the third quarter from FactSet illustrated that c.78% of S&P 500 companies "reported a positive EPS surprise and 62% of S&P 500 companies have reported a positive revenue surprise" .
- Granted, we are talking large-caps here. But the point is we are pushing into a potentially strong period of growth, is U.S. GDP forecasts remain on point.
- Per Trading Economics, " US economy expanded an annualized 4.9% in the third quarter of 2023, the most since the last quarter of 2021, above market forecasts of 4.3% and a 2.1% expansion in Q2…". It forecasts GDP growth of 1.8% next year and '25, which is in line with long-term trends.
Figure 2.
- Fundamentals well supported
In view of the economics for mid caps outlined above, MDY trades at 13.5x earnings, a shade above the category and FactSet's segment average. Coming 12-month returns are heavily impacted by starting valuations in most if not all asset classes, so this is a talking point. It is also well below large-cap peers, increasing the scalability of an upside move.
My judgement is that, such compressed multiples may have the following impact:
(1). Drive capital inflows to MDY and other mid caps. This is important, as there is crossover of MDY's constituents in other mid cap ETFs,
(2). Result in a re-rating of multiples in line with larger cap competitors,
(3). Result in a favorable total shareholder return (including all dividends paid up). Dividend growth has been lumpy from the fund in recent years, but nonetheless reasonably attractive at ~$6/share in the TTM. Growth from here would be remarkable.
Combined, these factors position MDY well for the investor with a moderate risk appetite who is looking to increase exposure across factors (size in this instance) without (i) buying into leveraged issues and (ii) risking sharp volatility and drawdowns. Hence, there is support for this holding over the coming 1-3 years.
Figure 3. MDY fund flows, October '22-October '23
Technical Factors for Consideration
With the latest price action, there are critical observations to be made on the technical side to guide price visibility going forward.
1. Regarding momentum
MDY has reversed off a multi-month downtrend and is testing previous highs. Note in Figure 4 it has made multiple attempts at this before. But this time several factors alternate from these occasions. Namely:
- The 2x gap up leading into November that took out the 20DMA high,
- The exceptionally high buying volume that was above the monthly average,
- Sustained buying volume after the curling off lows.
We hadn't observed these phenomenon in prior attempts of investors to lift the bid. In my view, short-term momentum is strong and supports scope for an extended rally.
Figure 4.
2. Skew, price distribution
Observations: The market profile below shows 3 weeks of price distribution. Leading into the market's push higher, we saw 2-3 trending profiles with minimal price acceptance sideways-mainly vertical. Investors cut through the $440s with little resistance on the long side, sending price to the lows discussed earlier. We saw a single print bottom and likely responsive buying at these lows. We've not got strong price acceptance at the $430s and 2x pockets of low usage from prior areas of disequilibrium, as seen below. There is reason to believe investors will fill these pockets of low usage in the coming weeks if we get above $450 in my view. We've already seen a range extension to the first pocket in the $460s. Given the breadth in volume distribution, and an incomplete bell curve on price, the $460-$470 region looks like an eye able target.
Key levels: $460-$470 on the upside, coinciding with the 2x pockets of low usage on price and volume. Buying the bottom of value below these levels is supported. Deep pockets here could be a magnet of price. On the downside, anything below $430 can't be ignored.
Actionable strategy: Longs beneath the 2x low usage pockets described are supported. Latest profile (short-term) is forming normal distribution. Adding in the longer-term context shows these deep pockets, which could be magnets for price.
Figure 5.
3. Directional bias of trend
There is trend support building for MDY as well. My observations are the following across all time frames:
Figure 6 . Short-term (60-minute chart, looking to coming days)-
- Clear breakout above the cloud with both price line and lagging line in situ. This was after the 2x gaps higher last week.
- Cloud twist with both turning line and conversion line curling higher evidencing the short-term momentum.
- Lagging line pulled back to cloud top but found immediate support and is pulling away again.
- Enormous buying volume leading us into this move. Note, volume often precedes price.
Key levels:
- We need $455 then $460 to be retaken, as these are the former highs and 100% retracement from October down ledge. Already crossed key levels to start the move.
- On the downside, $445 by end of November could push us back into the cloud.
Figure 7. Medium-term (daily chart, looking to the coming weeks)-
- About to test cloud and we are moving in counter-trend to cloud direction which calls for this to happen.
- Turning line and conversion line curling off lows, very supportive of continued reversal.
- Buying volume ascending after drying up in October.
- Almost taken October highs.
- Key levels again are the $455s then up to $470.
Figure 8. Long-term (weekly chart, looking to coming months)-
- Large marabuzo engulfing candle signifying the conviction of buyers leading into November. This pushed the price line up into the cloud. Lagging line was dragged back into the cloud with this move as well.
- Critically, the bullish engulfing candle took out the last 2 weeks range, and the open/close of the 3rd. A break above $460 has us above the cloud here.
- Volume was there to see it happen too-almost matched the last 2 weeks of sell volume, except for the bears, they couldn't drive it much lower. Bulls came in and took the market by the scruff of the neck.
Key levels:
- Absolutely critical to take out the marabuzo line from April that was tested then crossed later in the year. This looks to be a critical mark, and is at $450.
- We've been looking to ~$500 after this, the double top from January-July.
- On the downside, we can't break the former lows. This would change the character of MDY's technical prospects on a dime in my view.
Discussion Summary
In short, there are multiple points of confluence present in the data to suggest MDY is now a buy. We have near-term and mid-term catalysts that indicate a robust case for adding the fund to the long account. What should be considered is the balanced weighting of the fund, which may hinder the upside capture, vs. more concentrated offerings. On the flip side, my judgement is this will also prevent sharp drawdowns to one's portfolio, potentially smoothing risk-adjusted returns. So I'd advocate MDY is for the investor with a more moderate risk appetite in search of high dollar dividends (vs. yield, say). Still, there is a fundamental and technical case to own the fund at this point in time. As a reminder, my recommendations are:
Fundamental bias- Bullish across all time frames,
Technical bias- Bullish on short and long-term, awaiting signal on mid-term.
Net-net, I rate MDY a buy for the reasons discussed here.
For further details see:
MDY: Balance Drawdowns Amid Fresh Risk Appetite For Equities