Bloomberg News

Bond Rally Emboldens Bears to Short Industrials: EcoPulse

June 27, 2014

Bearish bets on an exchange-traded fund of industrial companies have risen close to a level last seen in 2012, reflecting investor skepticism about the strength of the U.S. expansion.

Short interest for the Industrial Select Sector SPDR Fund (XLI:US) totaled 55.3 million shares as of June 13, almost at an April level that was the most since July 2012, according to data compiled by Bloomberg. The number of shares traders have sold and haven’t yet bought back has risen about 64 percent year-to-date, the biggest increase among the nine SPDR ETFs that track the S&P 500 Index’s components.

The persistently high short interest in industrials illustrates “a healthy level of skepticism” about the economy, said David Mazza, head of ETF research in Boston at State Street Corp. Traders are betting this year’s winter slowdown wasn’t caused by harsh weather alone and signals a more lasting retrenchment in spending by consumers and companies, he said.

The U.S. economy contracted at a 2.9 percent annualized rate in the first quarter, the most since the depths of the 18-month recession that ended in June 2009, data from the Commerce Department show. Advance figures for the second quarter are scheduled to be released July 30.

In light of this sluggishness, “some investors are expressing a bearish macroeconomic view,” by targeting industrials because the group is economically sensitive and offers a high-beta play on growth, Mazza said. A stock with a high beta tends to rise or fall more than the broader market.

Bearish Investors

Some equity investors who are bearish about the industrial ETF are looking to their Treasury-trading counterparts as confirmation of their outlook, said Matt Maley, an equity strategist based in Boston at Miller Tabak & Co. That’s because “the bond market is telling us that growth continues to be sluggish.” In addition, forecasts for a pick-up in economic activity after the winter slowdown are debatable, he said.

Short interest on the industrial ETF has increased this year, while the yield on 10-year Treasuries has fallen to 2.5 percent from a two-year high of almost 3.03 percent on Dec. 31.

The industrial fund -- which includes Caterpillar Inc. (CAT:US), Union Pacific Corp. (UNP:US) and 62 others -- has lagged behind the S&P 500 ETF by 2.2 percentage points year-to-date, after leading the benchmark index by 8.2 percentage points in 2013.

Highly Correlated

This ETF is the most highly correlated to the S&P 500 among the nine select SPDR funds, “so if you want to make a bet against the market, it’s a good place to short,” said Walter Todd, who oversees about $1 billion as chief investment officer of Greenwood Capital Associates LLC in Greenwood, South Carolina. The benchmark index has rallied this year, closing at a record high June 20.

The relative performance of these stocks year-to-date is indicative of an economy that isn’t improving as strongly as many investors had hoped, according to Maley.

A rise in such bearish bets has been a “good, coincident indicator” of the group’s relative underperformance, Maley said. As short interest for this ETF climbed to “elevated” levels in March-July 2012 -- hitting a record high of almost 61.5 million shares in April that year -- the fund trailed the market by 4 percentage points during the same period.

Meanwhile, if history serves as precedent, industrials could experience further losses, particularly after the group broke a short-term uptrend relative to the broader market, said Jim Stellakis, founder and director of research at Technical Alpha Inc. in Greenwich, Connecticut.

Underweight Recommendation

In March of this year when this ETF was trading near a record high versus the S&P 500, Stellakis’s recommended an underweight allocation for these stocks. That’s because the group offered a “poor risk-reward,” lacking “follow-through buying.”

The industrial group has reached six highs relative to the S&P 500 since 2000, each time eclipsing the prior peak by 1.8 percentage points on average, according to Stellakis’ calculations. After hitting an “eventual peak,” this ETF would go on to lag behind the market by about 9.4 percentage points in the subsequent 194 days, he said.

Even so, Todd says a short on industrials -- a bet against U.S. growth -- is misplaced amid signs the world’s largest economy is improving. His fund currently holds 15 members of the ETF, including Honeywell International Inc. (HON:US) and United Parcel Service Inc. (UPS:US) because they are economically sensitive companies with global exposure, he said.

Expansion Intact

Indicators ranging from new home sales to hiring have been “rock solid” in recent weeks, suggesting the expansion is intact, Todd said. In addition, equity traders who look to the Treasury market to build their bear case could be losing sight of nonfundamental drivers of lower yields -- specifically a reduction in the amount of bond issuance by the government, as the budget deficit has declined, he said.

The U.S. economy is improving enough to withstand an increase in short-term interest rates next year as growth picks up, James Bullard, president of the Federal Reserve Bank of St. Louis, said yesterday at an event in New York. Meanwhile, bookings for capital goods, a proxy for business spending, rose 0.7 percent in May after falling 1.1 percent the prior month, figures from the Commerce Department show.

Still, Maley questions how bulls believe the economy is as strong as they say when the Fed continues to be “highly accommodative” by keeping interest rates low for the foreseeable future. Amid a decline in stock-market volatility, bearish investors are focusing on sector “pair trades” -- shorting a cyclical ETF while being long the S&P 500 -- because there may be more of a profit opportunity with this type of strategy, he said.

Not Compelling

The valuation also isn’t compelling now, as the industrial ETF currently is trading at a price-to-earnings ratio of 17.5, compared with 16.6 for the S&P 500 fund, according to Mazza’s calculations. “There are other sectors in today’s market that offer higher earnings growth and are more attractively priced.”

As a result, there’s a “barbelled rotation” under way that favors utility (XLU:US) and energy (XLE:US) stocks, which tend to outperform amid a slower-growth, inflationary backdrop, Mazza said. Industrials are considered a “bridge” between mid- and late-cycle sectors, so the short-interest level and in-flows into other equities are “mutually corroborative” of further weakness ahead for these stocks, he said.

“Some investors short the industrial ETF are indicating that their expectations for improved economic growth aren’t playing out.”

To contact the reporters on this story: Anna-Louise Jackson in New York at ajackson36@bloomberg.net; Anthony Feld in New York at afeld2@bloomberg.net

To contact the editors responsible for this story: Anthony Feld at afeld2@bloomberg.net Gail DeGeorge, Mark Rohner


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Companies Mentioned

  • XLI
    (Industrial Select Sector SPDR Fund)
    • $54.43 USD
    • -0.31
    • -0.57%
  • CAT
    (Caterpillar Inc)
    • $102.51 USD
    • -1.83
    • -1.79%
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