Playing Two Sectors Against Each Other
Featuring Michael Purves
Published on: May 2nd, 2019 • Duration: 16 minutesMichael Purves, chief market strategist & head of derivatives strategy at Weeden & Co., returns to Real Vision to considers two different sectors to play the current market environment: financials and utilities. Purves analyzes the relative valuations, discusses the importance of the yield curve, and reviews a specific way to make the trade using options, in this interview with Jake Merl. Filmed on April 30, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl sitting down with Michael Purves, Chief Market Strategist and Head of Derivatives Strategy at Weeden. Michael, it's great to have you back on the show.
MICHAEL PURVES: And great to be here.
JAKE MERL: So with the S&P trading near all time highs, what opportunities in the markets are you looking at right now?
MICHAEL PURVES: Well, I think it's pretty hard right now to be an enthusiastic bull here. We've seen a tremendous, a vicious rally from the December 24 lows. You can make a great case for valuation reexpansion back in December. You can't make that case anymore. We're halfway through earnings season. Earnings have come in really pretty nicely. I'm not surprised by any of that.
But the question is is to really get through 3,000 here in the S&P 500 and onwards and upwards, you're going to really need some increased growth. Meanwhile, there's a backdrop that the European and Chinese economic condition continues to be problematic. And that could trigger a real upward boost in the dollar if that data continues to be weak.
So there's a real risk here against a backdrop of we've added on two PE points just in three months. That's a very aggressive rally. But having said all that, I do think there are interesting opportunities that set up for good tactical trades, both on the long and the short side. And again, I'm talking really at the sector level, not at the single stock level.
JAKE MERL: So which sectors are you most interested in?
MICHAEL PURVES: Well, I'll tell you the thing that I have been constructive on on the long side has been the banks, the XLF ETF. And I think to explain that, there's sort of two primary factors that have been driven that thesis, one of which was extreme relative valuation. And I think the way I like to couch that is that look at the tech sector, the XLK ETF, relative to the financial sector. In this case, I'm using the XLF.
When you look at that price ratio, that's been blown out to 25-year extremes. I mean, there's only been one time we've ever seen that price ratio higher. That was in 2000, back when, of course, tech stocks were going to the moon. You saw a very elevated ratio back in 2008 for very different reasons, not because of tech doing so well, but because banks were being destroyed thanks to the great financial crisis.
When you look at relative valuation between those two sectors, that has also, as you would expect, really been heavily, heavily distorted. And I went back and back tested it, and you can see that every time that that has set up, it makes, actually, a really good long opportunity for the banks. You can measure relative to TAC, relative to the broader S&P 500. But that usually sets up a really nice signal. So that's one factor here.
The second factor is that what happened in late Q4 was this concept of obviously very severe equity market volatility, and then the Fed establishing its pivot, a process that started in November into December and really got cemented in January. And it kind of reinforced in the March FOMC. And you can tell in the money markets that you just have to look at the eurodollar curve or the Fed funds curve at 12 months. They're speaking aggressively and loudly that the Fed is-- if anything is going to be cutting this year.
It's kind of ironic that just back in September and early October, we were worried about too many hikes and Powell hiking us into a recession. Now that narrative has done a complete 180. It's my view here-- and this is a bit of a market call on rates-- but it's been my view that actually, there's a lot of reasons the back end of the curve will see higher yields in the next several weeks here.
And that's been sort of slowly edging higher here. There's a few reasons why I've had that view, one of which is that the inflation condition domestically certainly hasn't been one of inflation momentum. But it hasn't been one of contraction the way you had in 2015 and '16, when you actually had negative CPI prints. It's a much more stable floor. Again, in prior discussions I've done on Real Vision, I've laid out this case that structural disinflation is the defining feature of today's equity market.
And you have to recognize that, that the Fed's job of managing upside inflation risk is just radically different than it was 25 years ago. And you have to understand that and all that. Having said that, that doesn't mean that there's not a reasonably firm floor for a lot of this inflation data. If you look at the break even inflation rates, the spread between tips and nominal yields in the markets, those have been climbing from the lows up to basically 2%. Where were they in September? 2.2.
You look at inflation break over and throughout the eurozone, and even Japan, those have even started bouncing up a bit higher as well. So I just don't think there's a clear case for the Fed to make a rate cut here unless there's an out-of-consensus, out-of-expectation view that there's some really bad economic data coming domestically-- and I certainly don't see that, and I think most would say that would be a pretty much of a surprise.
So I think ultimately, the money market curves-- and it's really interesting if you plot out the 10-year nominal yield with the money market curves since October, it's been tick for tick. The 10-year yield is typically a bit more complicated in terms of what's driving it. That contraction from 3.1 down to 2.5 has been really all about nothing but the Fed's hiking trajectory, or the expectation of the Fed's hiking trajectory.
So my view is that if the money markets actually come up to where the Fed's dots are, the Fed push pause button condition, that could easily add on another 20, 25, 30 basis points to the back end, to the 10-year. And that's going to help re-steepen those yield curves, whether you're looking at three months to five year two to tens and so forth. And that's going to help that backdrop of earnings for the big money center banks.
I do want to make an important point here, which is that I'm not excited about the earnings stream coming out of the big banks. This is not like some new, exciting, oh my god, there's going to be some massive upside surprise to earnings. But has that group of banks been able to generate reasonably stable, reasonably high quality earnings growth through a lot of different yield curve conditions over the last four or five years? The answer is yes.
And they kind of just sort of keep grinding on. So when you have extreme valuation coupled with a pretty stable earnings profile, but with a little bit of a kicker that these yield curves are going to re-steepen and that not all is destroyed for banks, I think that sets up a good condition to be long banks.
Now you've seen my notes from earlier, and I was recommending XLF calls in June, and I've rolled those up twice now and taken profits. I still think there's room there. I'm not ready to do yet a third trade on the option side, but I think certainly if you're in equities and you want to overweight XLF, it's around $28 right now. I think you could see that grind up to $29 or $30 over the next three months there. And at some point I'll probably re-enter in a third bullish trade through a call option.
JAKE MERL: And what would you say is the biggest risk to this thesis?
MICHAEL PURVES: I think the biggest risk is that those yield curves get back into that negative territory again, or that there's some real negative announcements. But I think this is a pretty-- it may not be one of these things that's like going to make your year type of trades. But is it a good, solid place to put money when the market's just put in fresh highs? Valuation is tough to trade, but when it gets extremely distorted, I look at it as a really key factor because there usually is some renormalization of that.
So for the end of the second quarter type of frame, I think it's a good place to keep some money. Look, obviously there's big market risk that can happen here, and that will drag down all these things. But given how pounded these stocks got back in Q4 and into the early part of this year, it's been fine. And you know, they got through the earnings season. Basically, these ugly ducklings came through reasonably good.
I think, also, it's important to realize that their net interest margins for the big banks, they haven't collapsed through conditions over the last two years when the yield curves kept flattening and going even in negative territory in some instances. So this whole idea that oh my god, these banks will never be able to see this fantastic acceleration of earnings.
Well, that's maybe true, but that doesn't mean, actually, they'll be losing money. I think it's important to recognize, again, that these guys have been putting-- you just look at their numbers on an aggregate basis-- they have been putting in decent enough earnings growth.
JAKE MERL: So do you think the yield curve has bottomed and will start steepening altogether? Or is this just a short-term tactical move?
MICHAEL PURVES: My basic condition for the yield curves is that they're over the-- and this is a little bit longer time frame than just Q2, say, over the next 12, 24 months-- is that I think we're really in a different kind of condition here where they're really range bound. Some of them will go a little bit negative again. Some of them could re-steepen. Picking on the two tens, could that get up to 50 basis points? Sure.
And then could it go back down to zero? Sure. Is it gonna really signal the end of the cycle? I don't think so. I've talked with your colleagues about that in past interviews. I really think it's a very different condition given this role of structural disinflation and, of course, central banking and how that's weighing on the back end, and the relative pace of normalization of the front end versus the back end.
And I think it's also important to point out that the banks have actually had some very bad performance when the yield curves were very robust. You go back a few years here. So I think it's just important to clarify some of the noise and realize that you're buying these giant banks' franchises. They're post all the great financial fines that were being assaulted on them. They're not the sexiest investment out there, but for a condition right now, I think they're very solid.
JAKE MERL: So in addition to the financials, are there any other sectors you're looking at right now?
MICHAEL PURVES: Well, there's sort of an inverse, if you will, of the financials. And I've been out there pounding the desk on the short utility trade here. It's the same factors, basically. Rather than valuation get super cheap, as it did with banks, it got super rich for the utilities. Why? Because for volatility people go into defenses, and coupled with the fact that utilities, as high paying dividend entities with the Fed pivot, with that 60, 70 basis point contraction in the 10 year, they became extraordinarily loved, over loved.
And so just in the same way that I like long banks, I'm short utilities because A, I think you can go back and back test it, but every time that the relative valuation of utilities to the S&P 500 has become this elevated, it sets up a good 10%, 12%, 15% correction. You look at the dividend spread between utilities and the S&P 500 dividend. That spread, every time it got this narrow because the valuation got so strong on utilities, it sets up a good tactical move downwards.
Look, you know if the VIX is at 1213, the markets are bid-- we're having risk-on conditions. And you look at the VIX positioning, which has just hit record levels once again, you're sort of saying why are utilities still this loved? At some point, one of those two asset classes is wrong. And in my view, I think the utilities, if the market continues to sort of bleed higher here, people will be questioning why are they needing to own these utilities that don't pay a compelling dividend given the valuation you have to pay for now. And at the same time, if rates go higher, just as it's going to favor the banks, it's going to disfavor the utilities.
JAKE MERL: So what's the technical setup look like right now? Would now be a good time to go short?
MICHAEL PURVES: Yeah. You know, they've had a huge run over the last three or four weeks. That chart started getting much more bearish. I think it's going to start breaking down. Again, it would be nice to see the 10 year get up to 2.6, 2.65, and then you're going to start seeing people selling those things aggressively. So I think there's a nice move here. The XLU is a liquid ETFs that tracks the utilities. And I think that is really given to easily a $2, maybe $3 move lower by the end of the second quarter.
JAKE MERL: And so do you recommend shorting the ETF, or is there an options trade you suggest?
MICHAEL PURVES: Well, the way I like it-- because I do think there's going to be a quick little break lower here at some point in the next couple of months-- right now I like the regular June 57 strike put options. Right now they can be had for about $0.68. And the ETF is right now at about $58 and a little bit higher.
JAKE MERL: And would you have a stop loss, or is it just the premiium you pay is the Risk
MICHAEL PURVES: Yeah. The premium is-- for a simple option trade like this, I think you just have to assume that if you're wrong-- and you can be wrong not just on direction, but the timing of the move, or not getting enough of the move fast enough. So the premium, that $0.68 can vanish quickly. So if you're using options, just recognize that.
But at the same time, there's a lot of leverage there. So if you get a $3, $4 move, those options are going to balloon in value really fast. And that's where you also have to be disciplined with profit taking and managing your option position.
JAKE MERL: Well, Michael, that was great. Thanks so much for joining us.
MICHAEL PURVES: Thanks for having me.
JAKE MERL: So Michael is bearish on utilities. Specifically, he suggests buying the June 21 57 strike put option on utilities select sector SPDR ETF, ticker symbol XLU, for approximately $0.68. He suggests taking profits if the option doubles in price. In addition, Michael suggests overweight financials. That was Michael Purves of Weeden, and for Real Vision, I'm Jake Merl.