2023-07-14 11:21:41 ET
Summary
- I suggest a trade strategy using the equal-weighted Nasdaq ETF and Energy ETF, which complement each other's weaknesses and could lead to outperformance over the next three months.
- The strategy is contingent on avoiding a deep recession; the Energy sector could collapse from attractive valuations if a recession occurs. Risks include monetary policy lag, debt-strapped companies, inflation, Fed policy error, geopolitical tensions, and OPEC.
- I believe the combination of these two ETFs is greater than the sum of their parts, with indicators pointing to a bull market and potential economic expansion.
Markets have been challenging this year for many participants despite the historic rally. Bulls may feel they need to take some risk off the table and lock in some of the splendid outperformance, and bears feel like they need to catch up. I think I have a great trade conceptually that can be expanded upon or customized as desired.
Still, if you understand the primary rationale with the major ETFs, it can then be up to you to custom-tailor the logic to your specific strategy and research capabilities.
I'm going to describe each component here.
1. Use the Direxion NASDAQ-100® Equal Weighted Index Shares ETF ( QQQE ) to gain exposure to the catch-up trade occurring throughout the Nasdaq after the mega-cap components' prolific rise. If the recession is avoided or even narrowed, the rest of the Nasdaq 100 could have a lot of upside over the next three months.
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2. Energy Select Sector SPDR® Fund ETF ( XLE ) has been a laggard all year. After a historically stellar performance in 2022, the sector lagged in 2023 as previously beaten-down market areas shone and recession fear crescendoed. But the Energy sector is operating very lean right now and has brought down break-evens, so if economic activity remains robust, earnings may stay stronger than expected.
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Energy and Technology help to bolster each other because of their different stages in the industry life cycle. Technology companies are new and have high growth and low dividends. Energy companies have slower growth and externalities that mar valuation but have solid revenues, sturdy demand, and high dividends.
Both ETFs have the following:
- Good liquidity.
- Good Expenses.
- Great momentum.
These two ETFs naturally complement the weaknesses of the other. Energy has been a laggard while the Nasdaq has been a leader. Yet, the equal-weighted Nasdaq ETF mitigates concentration in the names that have outperformed and gives the holder a more diversified Tech upside. The XLE is heavily concentrated in the oil majors , which have an entrenched competitive advantage and are intrinsically undervalued .
The equal-weighted Nasdaq should be able to quiet some of the difficulty experienced by fund managers and retail investors when dealing with stocks as large as Apple ( AAPL ) and Microsoft ( MSFT ). It is difficult for many professional investors to go overweight these stocks, and this is part of the reason why names with still significant but less prodigious market weightings like Meta ( META ), Tesla ( TSLA ), and Nvidia ( NVDA ) have been able to sky-rocket beyond what their larger predecessor have been able to do.
Eventually, though, as the bull market continues in earnest, many managers will have to deploy capital, and it will be natural for a lot of it to chase Tech and not the largest Tech. So, I think Nasdaq is due for a catch-up trade the QQQE is better equipped to handle than normal QQQs.
Energy has a meager price/cashflow ratio which helps balance out the opposite characteristic in the equal-weighted Nasdaq ETF, whose valuation is supported by earnings much further in the future. This is significant because these earnings are pressured when rates are high. Yet, the historic gains in the Nasdaq ( QQQ ) from AI may be more fundamentally justified than many frustrated bears would admit, and momentum is on the bulls' side.
But XLE is so cheaply valued that it also provides a natural counterbalance to the increasingly stretched valuation of the QQQs, mainly since the Fed will likely keep rates elevated for a while. However, this indeed hasn't stopped long-duration stocks this year!
Still, the low price of Energy gives you a significant margin of safety that counteracts the valuation risk of the QQQE as economic uncertainty still looms, and inflation could always re-emerge. Of course, Energy also provides an inflation hedge, where QQQE is particularly well suited to take off if it continues going down consistently. The QQQ has outperformed the equal-weighted, but that is just starting to reverse.
This turn in performance seems to be coinciding with the turnaround in the Energy sector, and I suspect these two ETFs will outperform together for the next 30-90 days. I will reassess the trade in 30 days.
Tough Year for Many Managers So Far, But Economic Data Shows Bullish Finish Possible
This has been a tough year for performance after a historically tough year last year. A lot of people don't realize that as the clock ticks toward December, there will have to be many decisions made about where to put money to stay ahead of the benchmark. You get fired and get no bonus when you fall behind. So, many are likely starting to feel a bit squeamish.
A lot of managers have missed the fiery "Magnificent Seven" trade that saw some spectacular games in large-cap names while the rest of the market was largely left behind. After the bullish reading on June CPI and then the follow-through on PPI coming right on the heels of Chinese data that was near deflationary, the inflation picture is looking suddenly a lot better than it was a week ago.
You can see at the index level things have been much more muddled and subdued. Energy has lagged behind everything, and it has begun to outperform in the last few days. Given the economic strength and recent strength of the consumer and seasonal patterns, it is likely to see some upside in Energy in the short and medium term if the recession is avoided.
Performance has also broadened significantly over the last month; I suspect this will only continue as the economic weather has significantly improved this week.
So, this is all very positive, and I think it's getting very conclusive now that we have entered a bull market, and the rally is broadening out. Market breadth has increased, and small-cap outperformance and cyclical areas like Transports do not indicate an imminent recession. There's further evidence of strength throughout the economy and market:
- The Fed tightening cycle is over, or nearly over , and gains from AI have been more fundamental than frustrated bears would like to admit, so it is likely this rally has legs.
- The gain in large-cap Technology like Microsoft ((MSFT)), Apple ((AAPL)), and others has been mainly due to enthusiasm for Artificial Intelligence. Still, these firms will continue to do well if we avoid recession.
- The Fed has given the all-clear to the market, permitting the current rally to continue, or at least as long as the downward trajectory of inflation continues.
- When aggregating economic data at the state level and determining probabilities for recession, the chances seem minuscule .
- Indicators are showing resilience in the economy and the potential that an expansion may even be starting. If we are early cycle rather than late cycle, as many market participants still think, then small caps should soar.
- Housing market strength has been impressive, particularly in the face of high rates. Consumer confidence recently hit a 17-month high .
The economic data and the successive soft labor and inflation data mean that it's likelier that the rest of the market will begin catching up to the dramatic outperformance of the titans of Technology. I think I have a great way to play the "catch-up" I see likely in the coming quarter without becoming over-exposed to the leaders that have sometimes performed in the triple digits.
My base case is now that we avoid recession and that the bull market picks up steam. In this event, I think the QQQE and XLE pair will perform excellently together and should outperform the S&P 500 over the next three months.
My bear case would essentially be that a devastating earnings season leads to an ugly reversion of positive performance, or it becomes apparent that a severely adverse recession has started.
Risks and Where I Could Be Wrong
This trade is pretty much wholly contingent upon avoiding a deep recession. If a deep recession occurs, the Energy sector could collapse even from attractive valuations. Remember, too; there are massive risks from the externalities associated with climate change and the government's regulatory efforts to mitigate it. In the short term, the price action for Energy will likely be to the upside, helped along by a potential short squeeze .
Still, there are ominous signs that a recession could be imminent, and many folks are worried about the following risks:
- Monetary policy lag and QT cause a rapid reversal of economic conditions.
- Debt-strapped companies start to buckle under the weight of higher rates causing unemployment and diminished energy demand.
- Inflation returns.
- Fed policy error.
- Escalation of geopolitical tensions.
- OPEC.
For the equal-weighted Nasdaq ETF, I think the main risk is valuation, given the concentration in Technology and mostly other high-valued stocks. Of course, a recession that threatens growth could be tough on the equal-weighted ETF versus the normal Qs because the same Magnificent Seven that has led the gains this year also benefits more from a safety trade than much of the rest of the index, which is more cyclical.
However, many risks could cause one or both of the ETFs to go down enough to render the trade ineffective at useful outperformance and diminish the usefulness of the portfolio characteristics of the combo.
Conclusion
I think there are a lot of folks who have lagged in performance this year after a historically bad year. There are also a lot of folks who are rightfully risk averse given the lack of clarity still pervading markets in the wake of COVID-19 and a generational deterioration in geopolitical conditions.
There's a general Value/Growth dichotomy here that I think should make the combination of these two ETFs greater than the sum of their parts. The indicators point to catching up because the value is starting to outperform growth, and all indications are that a bull market and maybe even an economic expansion is starting.
Those with the resources can customize the Energy and Equal Weighted Nasdaq ETFs concept to identify a more specialized strategy focusing on single stocks. For instance, there could be more specialized ways to take advantage of Energy below the sector level. But the main strategic takeaway is that the laggards of XLE and of the QQQs have a good shot at being the leaders for the next few months.
One easy way I think will help capture outperformance over the next three months is a position with 50% XLE and 50% QQQE. I think this combination will prove more than the sum of the parts. This bull market is heating up, but the early leaders will slow and make room for these two ETFs at the vanguard of relative performance.
For further details see:
QQQE And XLE: Balanced ETF Strategy For The Next Phase Of This Bull Market