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I want to touch further on my article “4 Signs That Market Is Shifting To Risk-On” that was published on 9 September 2019, where I wrote down my observations that the technical charts of selected equity indices, gold, and Treasury yields were painting an imminent risk-on picture, very far from the recessionary warnings that have dominated mainstream financial media.
Interestingly, on Monday, there was an out-sized surge in Value stocks relative to Momentum stocks, which leads me to think that we may be at an inflection point where Value stocks are poised for a strong rally – out of which my top sector pick is the absurdly out-of-favor SPDR S&P Regional Banking ETF (KRE).
Momentum stocks have vastly outperformed Value Stocks in the past few years, as seen from the price ratio of iShares Edge MSCI USA Value Factor ETF (VLUE) / iShares Edge MSCI USA Momentum Factor ETF (MTUM) below. Data compiled by Bespoke Investment Group showed that Monday’s move was Value’s strongest daily performance relative to Momentum since the inception of both ETFs in 2013.
Value stocks such as Financials and Energy are more cyclical in nature, and inflows into Value indicate improved sentiment in the macro backdrop. Value’s extended underperformance relative to Momentum has coincided with subdued global interest rates in the past, and Monday’s out-sized rotation into Value from Momentum could be indicative of the market starting to price in higher interest rates going forward.
Monday’s rotation also coincided with a rebound in the US 10 Year Treasury yield from its 7-year major support of around 1.40%. The similarity in timing of these two moves add credence to my thesis that we are likely to see a sustained rise in yields from here (Read: risk-on). The market has been overly expectant of lower interest rates, and is unprepared for a move higher in yields. After all, the long Treasury (TLT) trade is currently the most overcrowded trade in the world. Further rise in yields will likely be a self-feeding mechanism, as it would spur a sharp and painful squeeze in the long Treasury trade, thus giving yields a tailwind to move higher.
US 10 Year Treasury Yield
Financials will likely be a main beneficiary of rising interest rates, as that would improve their net income margins – or the profit that banks can glean from lending money (loans) and borrowing money (deposits). Within this sector, there is a very interesting opportunity.
The SPDR S&P Regional Banking ETF (KRE) has underperformed the Financial Select Sector SPDR ETF (XLF) and the price ratio of the former over the latter is near a 5-year low. This is because the constituents in KRE mostly depend on their consumer and commercial units to make money (loans, mortgages, deposits), and thus have been hurt by falling interest rates. Some of the constituents in XLF can depend on their investment banking and trading units to make money, and thus are less reliant on interest rate movements.
KRE
XLF
As such, a potential rise in interest rates could be synonymous with adding rocket fuel to KRE’s share price. In terms of timing, KRE is trading near an intersection of major support levels, which have been holding up its share price. Buying KRE at market ($53.24) would be very reasonable as the ETF is trading so close to its support levels. The ETF is also trading close to 20% below its all-time high, and provides a dividend yield of about 2.4%.
KRE Weekly Chart
The most immediate catalyst for KRE to take off would be productive trade talks between US and China. Both countries are set to meet for talks in early October, and early signs have so far been promising. China has agreed to roll back tariffs on Soybeans and pork from the US, while Trump has hinted that an interim trade deal (which may reverse some of the imposed tariffs) may be in store.
Conversely, the most immediate risk for this trade would be a collapse in US-China trade talks, prompting a flight-to-safety into bonds and spurring global central banks to cut interest rates further, thus hurting the margins of regional banks.
While a trade deal could be almost binary in determining whether the market turns risk-on or risk-off, I would prefer to build a long exposure in KRE prior to the outcome of the key trade talks in October, with the expectation that Trump will want some semblance of a positive trade deal before his election in 2020 with a recent poll showing that most voters will blame Trump for a recession. As such, I would ascribe a higher probability to US and China agreeing on a trade deal than otherwise.
A positive trade deal will most likely shift yields higher, and subsequently propel KRE much higher to my target of at least $62 (all-time high is close to $66).
Previous trading calls for The Naked Charts in the last 3 months
If you like what you read and want high-conviction trading calls delivered straight to your inbox, do check out my Marketplace Service The Naked Charts, where I identify mature technical chart patterns that are on the cusp of huge, profitable, sustainable breakouts. The core aim of my service is to be both profitable and educational for you, such that over time you will be able to identify similar breakout patterns for yourself.
Disclosure: I am/we are long KRE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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