Richard H. Driehaus (1942-2021) Requiescat In Pace

A true giant in the world of investing, a visionary, a philanthropist and former client, Richard H. Driehaus, passed away on Tuesday of last week. He will be missed by the many thousands of souls he touched. Richard H. Driehaus (1942-2021) Requiescat In Pace.

A Challenging Investment Environment

One would think that with a stimulative monetary policy, stimulative fiscal policy and an incredibly positive outlook for the economy, investing would be simple. Not so.

This is a challenging environment for portfolio managers as the dispersion among themes, sectors and individual stock performance has increased dramatically. As COVID gripped the nation and the globe investors became comfortable with a strategy overweighting growth stocks. This was appropriate in a period when the outlook for economic growth was uncertain and interest rates at the long end of the curve were low. But with both GDP forecasts and longer-term interest rates rising this is no longer the case.

As 2021 began a tipping point in investment sentiment was reached as the reopening of the economy became more of a reality than a hope.

The first expression of this change in sentiment about the economic outlook was apparent in the bond market when the yield of the 10-Year T-Note (as represented by the TNX index) broke out to the upside from a multi-month base pattern on January 6. See chart below. Base pattern breakouts like this usually imply the beginning of a more sustainable uptrend.

Daily Chart of the TNX Index (CBOE 10-Year US Treasury Yield Index)
The lines on the chart denote the levels that defined important upside breakouts. The catalyst for the January 6 breakout was the Democrats winning both Georgia Senate seats. The second breakout on February 16 occurred when the idea that President Biden’s $1.9T relief package would be approved by the House became the consensus view. Both events favored the view that President Biden’s stimulative policy agenda would be implemented.

The upside breakout by the yield of the 10-Year T-Note signaled the beginning of an intermediate-term uptrend for yields.

Where might this uptrend carry yields? From a technical perspective there is a fair amount of resistance in the 1.70%-1.97% area. The TNX index closed Friday at a yield equivalent of 1.635%.

The move higher in longer-term yields implies big changes for stock market leadership. Growthier sectors, industry groups and individual stocks with high multiples will see their relative performance pressured. This is not to say that they cannot continue to move higher.

Investing with Stock Market Leadership in Flux – The Trend is Your Friend

Relative earnings momentum is an important consideration in stock or sector selection. It appears to be particularly important currently because of what the bond market is saying about the economy. Yields appear to be rising as forecasts for GDP growth are rising. The result is that companies more leveraged to GDP growth are likely to see a pickup in their relative earnings momentum.

Investors have bought into this idea and we can see this reflected in a chart of the relative performance of the iShares S&P 500 Value ETF to the iShares S&P500 Growth ETF. See chart below.

Daily Chart of IVE (iShares S&P 500 Value Index).
Center panel shows 14-day RSI currently overbought.
Lower panel shows the ratio of the iShares S&P 500 Value ETF to the iShares S&P 500 Growth ETF. The upside breakout and initiation of an intermediate-term uptrend is evident.

No matter what our investment strategy is at some point we need to be tactical. In a highly correlated stock market (one in which the dispersion of returns across themes, sectors and stocks is narrow) ‘timing’ the market (which implies the use of short or intermediate-term extremes in price momentum, positioning and sentiment) is useful for entries and exits no matter your strategy. In the current environment the performance dispersion among themes, and industry groups is high. In this type of environment using broad market gauges as your guidepost is unlikely to help your relative performance.

We understand that most portfolio managers are benchmarked to the S&P 500 so straying far from the S&P weightings creates ‘career risk’.  But at the same time, we can stray within our risk tolerance to try and improve our relative performance.

Investing with the trend is always a smart move. There is a saying in technical analysis “the trend is your friend.” If you can define the trend and stay with it, you can profit.

In the current environment with sector and industry group performance dispersion we want to invest with the relative performance trend and only trade the countertrend moves.

First, we are going to identify the relative performance trends of industry groups, sectors or themes that we think are most affected by the recent rise in the 10-year T-Note yield. It is this rise in yield that is generating the stock market’s current bout of volatility.

One good example currently is the Value/Growth relative performance relationship. We want to overweight value now that an uptrend is in place and if we wish use countertrend moves opportunistically.

We can implement this strategy by digging deeper and using industry groups or individual stocks associated with the relative performance trends of value and growth.

As an example, financials represent a subgroup within value. The S&P Financial Select Sector SPDR ETF relative performance versus the technology sector shown in the bottom panel has entered an intermediate-term uptrend. This warrants an overweight in financials versus technology.

To wrap things up the uptrend in the yield of the 10-year T-Note is likely to persist. The rise in rates is having a significant impact on relative theme and sector performance in the stock market. Sectors, themes and individual stocks leveraged to economic growth have initiated or are on the cusp of entering relative performance uptrends. This is the case for financials, industrials and materials versus technology. Value appears to be in a solid uptrend versus growth.
Keep in mind that in technical analysis multi-month base breakouts tend to initiate trends that persist. We have seen this take place in the value/growth and financial/technology relative performance relationships. On the cusp of similar breakouts are industrials and materials versus technology.

This week’s  commentary provided by Marc Sutin, the very highly regarded technical analyst and founder of Intuitive Analysis LLC, former partner of mine at Knight Capital Group, and dear friend for many years.

Flickr photo: @thomashawk

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