Utilities And XLU: This Hated Sector Continues To Soar – A Great Exit Opportunity Now Exists – Utilities Select Sector SPDR ETF (NYSEARCA:XLU)

Utility stocks, or the utility sector in general (XLU), has been one of the most hated sectors by market pundits and popular analysts. Utilities are often viewed as “defensive,” making them a “no-touch” for anyone that has a generally bullish view on the stock market or the economy. This unwarranted and misunderstood perception of utility stocks has led most investors to have little or no exposure to one of the best S&P 500 sectors over this entire economic expansion, and the last two years more specifically.

Utilities generally outperform when growth is slowing. Utilities also benefit from falling inflation expectations. The Coronavirus Outbreak has caused the market to shift back toward an environment of growth slowing and falling inflation expectations, providing an extra boost to the XLU ETF. While secular economic conditions favor XLU as a long-term hold, market conditions are presenting an attractive exit opportunity as growth and inflation expectations slide with each negative headline.

The SPDR Select Sector ETF (XLU) is the most popular ETF for utility stocks with 28 individual holdings. The ETF is fairly concentrated with more than 60% exposure held in the top 10 names.

XLU Top 10 Holdings:

Source: State Street Global Advisors

The ETF also is fairly concentrated in terms of industry exposure. More than 60% of the industry allocation comes from electric power utilities.

XLU Industry Allocation:

Source: State Street Global Advisors

The extreme concentration of exposure to the electric power industry, a heavily regulated and non-discretionary spending item, results in XLU exhibiting strong performance characteristics during economic downturns.

Below, I will outline several reasons why XLU continues to soar, but also why an attractive exit opportunity exists.

XLU Holding Period: Total Return (%):

Source: Bloomberg, EPB Macro Research

At EPB Macro Research, after holding an overweight position in XLU for nearly two years, we have closed out our long position. XLU gained more than 40% in total return terms over the holding period (black line). After closing the position in utilities at the end of January, XLU has continued to rise (red line) as both growth and inflation expectations edged lower.

When Growth Slows, XLU Outperforms

Utilities are branded as a “defensive” sector, mainly because the business model of an electric utility is far less volatile than an industrial stock or bank stock subject to the ebbs and flows of the global economic cycle.

Thus, when economic growth is trending lower, or a recession is becoming more probable, investors are willing to pay a higher price for a more stable stream of income. We can prove this several ways.

First, when growth is declining, the utility sector nearly always makes the top of the list in terms of performance. History has held true as XLU continues to post staggering gains during a period of declining growth.

Economic growth has been empirically declining since Q3 2018. The chart below of personal consumption + private investment or “core GDP” highlights this deterioration in economic growth.

Real “Core” GDP Growth, Year-Over-Year (%):

Source: Bloomberg, EPB Macro Research

Several other indices, including the EPB Macro Research Coincident Index, confirm the persistent decline in economic growth since the middle of 2018.

If we stack the performance of the major S&P 500 sectors since the peak in economic growth, we find a pattern that is similar to history.

Utilities, real estate, and consumer staples have outperformed the market – very defensive leadership. Historically, technology stocks underperformed during periods of declining growth but during this economic expansion, technology has led the market during periods of declining growth.

S&P 500 Sector Performance Since Q3 2018:

Source: Bloomberg, EPB Macro Research

When economic growth declines, investors pay more for stability (utilities) and technology stocks. Technology stocks (this economic expansion) have performed well during periods of slowing growth because any growth investor can find gets priced at a premium. Technology can be tricky, however, as outperformance can quickly devolve to underperformance if “growth slowing” intensifies toward “recession.”

We can further prove the premium paid for XLU during periods of declining growth by looking at the relative PE ratio of XLU and SPY.

The chart below shows the PE ratio of the S&P 500 divided by the PE ratio of XLU. As the ratio (black line) is moving lower, the valuation of XLU is increasing relative to SPY.

Global Manufacturing PMI and Relative PE Valuation:

Source: Bloomberg, EPB Macro Research

As growth declines, proxied above via the global manufacturing PMI, the relative valuation of XLU increases.

Prior to the Coronavirus outbreak, early signs of a cyclical rebound in global industrial growth were emerging. The magnitude of the upturn was always suspect, but the data was almost undoubtedly set to get “less bad” across global manufacturing economies.

The Global PMI started to edge higher and XLU started to underperform the market.

The outbreak of the Coronavirus has caused large disruptions to many industries, surely to be reflected in upcoming economic data.

Investors are positioning for an environment of growth slowing, shifting away from any cyclical rebound, until more information is known about the extent of the economic damage.

When Inflation Expectations Decline, Utilities Trade At A Premium

Similar to economic growth, when inflation expectations are falling, interest rates generally decline and the high, stable dividend yield of XLU gets priced at a premium.

The chart below shows that when long-term inflation expectations decline, the relative valuation of XLU increases or utilities get more expensive relative to the S&P 500.

30-Year Inflation Expectations and Utilities Relative PE Ratio

Source: Bloomberg, EPB Macro Research

The Coronavirus outbreak has caused fears in many markets, including commodities. The price of oil, copper, and other exchange-traded industrial materials have declined in fear of faltering demand.

Inflation expectations had been rising over the last several months, first due to investor psychology related to balance sheet expansion, and later due to a true cyclical upturn in industrial inflation pressure.

The trend in inflation expectations has turned back down as investors wait for more information.

The Coronavirus outbreak has caused the market to shift back into a mode of growth and inflation expectations falling. XLU, on a relative basis, massively outperforms when both growth and inflation expectations are declining simultaneously.

Why I Sold My Holding In XLU

Prior to the outbreak of the Coronavirus, the US economy was showing declining rates of growth, but cyclical inflation pressure was starting to emerge.

Secular economic conditions such as demographics and debt limit the magnitude of any cyclical upturn but the direction had shifted nonetheless.

The CRB index of raw industrials, a basket of commodities not easily speculated on in the futures market, had shown an increase in price growth from roughly -15% to +3%; a clear upturn.

Of course, this upturn in cyclical inflation pressure never had the chance to rival the global relation of 2017-2018, but a minor change in direction was seen in the data.

CRB Raw Industrials, Growth Rate:

Source: Bloomberg, EPB Macro Research

Furthermore, cyclical inflation pressure was seen in the growth rate of core import prices, a sign that the global economy was starting to see the downturn in inflation moderate.

Core Import Prices, Growth Rate:

Source: Bloomberg, EPB Macro Research

In combination with other leading indicators of cyclical inflation pressure, including the ISM prices paid index and more, it was clear the start of a small cyclical upturn in industrial inflation pressure was underway.

This presented a good opportunity to close the nearly two-year position in XLU.

Upon closing the position, the fears surrounding the Coronavirus intensified and shifted market expectations away from any possible upturn in inflation pressure and back toward disinflation and growth slowing.

Why XLU Continues To Perform Well

The lockdown in the Chinese economy already is starting to have broad economic implications.

Most recently, the ZEW Germany Current Situation Survey showed that sentiment in February notched down.

ZEW Survey Germany Current Situation:

Source: Bloomberg, EPB Macro Research

The auto sector was hit the hardest in the ZEW Survey for February. Industrial data over the next several weeks is likely to be negatively impacted with no clear signs as to when normal activity will resume.

ZEW Survey Germany Current Situation: Automobiles

Source: Bloomberg, EPB Macro Research

Expectations of the future also ticked lower in Germany.

ZEW Survey Germany Expectations

Source: Bloomberg, EPB Macro Research

Risks are clearly tilted to the downside. The impact of the Coronavirus outbreak is derailing the prospects of a small cyclical rebound in industrial growth and industrial inflation pressure.

XLU – A Long-Term Favorite With Secular Tailwinds

While I closed the position in XLU for underlying cyclical reasons, including an increase in industrial inflation pressure, XLU has many secular tailwinds and remains a great sector for investors with a longer buy-and-hold focus.

Economic growth in the United States is in secular decline, mainly due to weakening demographics and high levels of public and private sector debt.

Core GDP growth (consumption + investment), has declined to 3.0% on a 10-year annualized basis, a clear downshift from the prior 50 years.

Secular Decline In Underlying GDP Growth:

Source: Bloomberg, EPB Macro Research

Weaker levels of trend economic growth will keep a lid on long-term interest rates, creating a massive tailwind for a sector that’s viewed as a high yielding bond proxy.


In short, XLU outperforms the most during a period of declining growth and declining inflation. Over the long run, secular conditions favor a decline in growth and inflation, making XLU and its components a sound part of a balanced portfolio.

On a cyclical basis, before the Coronavirus, underlying economic trends were starting to show an improvement in global industrial growth and a modest pickup in industrial inflation pressure. As a result, I decided to close the position in XLU.

The Coronavirus is causing the market to price-in an environment of growth slowing and inflation slowing, resulting in massive outperformance of XLU.

Shocks can temporarily change the direction of growth and inflation expectations. Still, if the “shock” is resolved quickly, the economy typically has a “rubber-band” effect and slingshots back toward the original trend.

It’s unlikely that a negative shock completely negates an underlying trend, and typically, this occurs only with prolonged disruptions and job losses.

Therefore, I would be using this rally in XLU as a selling opportunity, hedging against the market reverting to its underlying trend of growing (albeit mild) industrial inflation pressure.

If this negative shock lasts several months, and job losses/recessionary conditions re-emerge, portfolio construction and an equal balance of “risk” is mainly tasked with counter balancing a negative shock.

A great opportunity exists to take down highly-defensive exposures. I remain overweight Treasury bonds, however, as the underlying trend for US economic growth remains lower.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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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EMB And PCY: Look To Emerging Market Bonds To Diversify Your Portfolio – Invesco Emerging Markets Sovereign Debt Portfolio ETF (NYSEARCA:PCY)

There was much talk about emerging markets outperforming in 2020 after years of lagging developed market returns. Now with the coronavirus starting in China and spreading throughout the world, that tune has changed. From December 31 through January 13, the iShares MSCI Emerging Markets ETF (EEM) was up 3.19%, handily outperforming the S&P 500 Index (SPY) at 1.78%. As the news started arriving on January 13 of the virus being detected in other nations, EEM took a dive. From January 13 through February 6, EEM dropped 5% and SPY rose 1.75%. Abandoning emerging markets altogether is not necessary, though. If you are looking for emerging markets exposure in your portfolio, emerging markets bonds are a much better option than equities. The Invesco Emerging Markets Sovereign Debt Portfolio ETF (PCY) is a wise choice to fill this role in an investor’s portfolio.

Not every emerging markets bond fund is the same. The iShares JPMorgan USD Emerging Markets Bond ETF (EMB) is the industry giant with close to $16 billion in assets. Just because it is the largest, doesn’t make it the best investment. The Invesco Emerging Markets Sovereign Debt Portfolio ETF is another good choice. PCY has outperformed EMB on a short-term and long-term basis. In 2020, it is ahead by 50bps, and over ten years, it averages 60bps more per year than EMB.

































China exposure




5yr Upside capture




5yr Downside capture




data through 2/6/2020

iShares and Invesco did not build their funds the same way. EMB and PCY both buy US-dollar denominated debt, which eliminates currency risk associated with foreign bonds. EMB is a market-cap weighted fund, whereas PCY is equal-weighted. PCY’s investment committee selects the 35 countries the fund will invest in based on their economic outlook for each country, then purchases the top three yielding bonds from each country. So, each country gets about a 3% weight in the fund and each bond makes up just less than 1% of the fund. This leads PCY to have greater frontier market exposure, which is one of the largest factors in PCY’s outperformance of EMB. Frontier markets have proven to be less correlated than emerging markets to developed markets. With a correlation ratio of 0.05 between the S&P 500 (SPY) and iShares Frontier Markets fund, it is far less than the correlation of EEM and SPY at 0.74. PCY has about 25% of the fund in frontier markets.

PCY currently has 46% of its portfolio in investment grade (BBB or higher) bonds, while EMB has 56%. All of this is made up of government issued bonds, not corporate bonds. Invesco has only just over 2% of the fund at a rating of C or less, which are Argentine and Lebanese bond that have been downgraded. PCY takes on additional credit risk by having more below investment grade bonds (48% of the fund). This additional credit risk helps boost PCY’s yield but opens it up to a higher default rate. The default rate has been kept under control by Invesco’s selection process and weight limits. This additional yield has helped the total return of the fund.

Besides the general overweight to frontier markets, PCY’s outperformance can also be associated with country and issue selection. The fund’s three bonds in Bahrain contributed most to its outperformance and this was an overweight position compared to EMB. Also, even though the overall weight of Saudi Arabian bonds is less in PCY than EMB (2.8% vs. 4.3%), the selection of the three bonds outperformed the Saudi bonds in EMB. The same is true for the United Arab Emirates bonds. Venezuela and Argentina were the largest drag on performance. Venezuela has been in default for the past three years, so the bonds are no longer in the portfolio, but Argentina is on the brink of default with a new government and high inflation.

The Invesco Emerging Markets Debt fund is not without risk. With all bonds there is credit risk that the issuer will not repay the principal upon maturity. As mentioned, by having a larger percentage of the fund in the below investment grade spectrum, there is greater credit risk than EMB. PCY has also shown more volatility than EMB but that volatility has paid off in the form of return. Five-year standard deviation for PCY is 6.45% while EMB’s is 5.75%. So, you must be able to stomach some greater ups and downs to own PCY. This is highlighted in 2018 when markets were down for the year and PCY underperformed EMB by 70bps. Bond funds like PCY are also affected by interest rate risk. As rates increase, bond prices fall. Interest rates have been getting cut by central banks around the world to support the global economy which has helped boost bond prices, but when this rate cycle ends, all bonds will suffer in price. The weighted average maturity of PCY is just over 17 years but is higher than EMB. This can lead to more interest rate risk, as longer dated bonds are affected by changes in interest rates more.

“It isn’t surprising to see emerging markets debt continue their relative underperformance (to US Treasuries) here. EM debt is actually up about 1% on the year, so the drop in this ratio is more due to the strong rally in U.S. Treasuries. It’s worth noting that EMB has just 3-4% of assets dedicated to China, so the coronavirus has less impact here than in other segments of the market,” as pointed out in this week’s Lead-Lag Report. By choosing to add emerging markets debt to your portfolio, you can enhance your fixed income return while protecting your equity sleeve. With global GDP expected to take a hit and China’s 2020 GDP estimates being reduced close to 5%, you can expect a tough earnings environment for stocks. This is reason enough to avoid EEM with over a third of its assets invested in China. China announced a $242 billion stimulus plan last week and Brazil just cut interest rates by 25 bps. These stimulating measures should give a boost to bond prices as yields drop. Also, last week, Argentina was able to avoid default by making a large bond payment many had feared wouldn’t get met. So, there are positive signs in the fixed income market that nations are proactively supporting their economies and helping stabilize bond prices.

The best way to add emerging markets exposure to your portfolio is through fixed income. Over the past ten years, PCY has far outperformed domestic bonds and emerging markets equities. Given the current climate of slowing GDP, reduced earnings, and fears of China’s reduced growth, now is the best time to swap into emerging market bonds from emerging market equities and buy into the Invesco Emerging Markets Sovereign Debt Portfolio ETF.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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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XLV Weekly: Minor Price Discovery Higher Back Into Major Supply Overhead – Health Care Select Sect SPDR ETF (NYSEARCA:XLV)

In this article, we examine the significant weekly order flow and market structure developments driving XLV‘s price action.

The highest probability path was for price discovery lower, barring failure of 104.24s as resistance. This probability path did not play out as minor price discovery lower early week resulted in buy excess which halted the sell-side sequence early in Monday’s auction. Price discovery higher then developed to 104.84s where sell excess developed within key supply, driving price lower to 103.40s ahead of Friday’s close, settling at 103.93s.

10-14 February 2020:

This week’s auction saw a minor probe lower in Monday’s auction, achieving the weekly stopping point low, 102.58s. Buy excess developed, driving price higher to 103.59s as buying interest emerged, 103.31s/103.50s, ahead of Monday’s close. A minor gap higher open developed in Tuesday’s trade as buy-side continuation developed to 104.30s, testing last week’s key resistance as buying interest emerged, 103.94s-104.22s, into Tuesday’s close.

Tuesday’s late buyers initially held the auction as a buy-side breakout attempt developed above last week’s key resistance, achieving the weekly stopping point high, 104.28s. Structural sell excess formed early in Wednesday’s trade, driving price lower back below prior key resistance as the breakout attempt failed. Constricted price discovery lower developed through Wednesday’s auction, achieving a stopping point, 103.64s, early in Thursday’s trade. Sellers trapped there as balance developed, 103.64s-104.28s, into Thursday’s close. A minor probe lower developed to 103.43s early in Friday’s auction where sellers trapped and minor rotation higher ensued to 104s ahead of Friday’s close, settling at 103.93s.

This week’s auction saw a sell-side attempt to push price lower fail early week before rotation higher developed to 104.84s within key supply overhead. Within the larger context, balance development continues, 105.08s-98.81s, following 2019’s rally.

Looking ahead, the focus into next week will center upon market response to this week’s key resistance, 104.40s-104.83s. The market continues to seek resistance, within a buy-side phase, in a process called price discovery. Sell-side failure to drive price lower from this resistance would target new, all-time highs. Alternatively, buy-side failure at this resistance would target key demand clusters below, 100.84s-98.82s/95.67s-93.71s, respectively. From a structural perspective, the highest probability path near-term is buy-side barring failure of 102.56s as support. Within this near-term context, the intermediate-term (3-6 month) bias is neutral between 105.08s and 98.81s.

It is worth noting that breadth, based on the S&P Healthcare Sector Bullish Percent Index, is now trending higher within the bullish extreme area. Stocks more broadly, as viewed via the NYSE, exhibit a current consolidation of bullish breadth. Asymmetric opportunity develops when the market exhibits extreme bullish or bearish breadth with structural confirmation. A cautious bullish bias remains warranted as market structure is bullish while breadth approaches bullish extreme levels.

XLV Breadth 14Feb20

Looking under the hood of XLV, we see that based on one year’s data, Johnson & Johnson (NYSE:JNJ) and UnitedHealth Group Inc. (NYSE:UNH) have contributed substantially to the recent rally (121bps and 99bps respectively). This duo represents approximately 17% of the entire XLV, and as such, is likely to have material effect on XLV itself.

XLV Holdings 14Feb20

The market structure, order flow, and sentiment posture will provide the empirical evidence needed to observe where asymmetric opportunity resides.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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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ETF Deathwatch For January 2020

By Ansh Chaudhary

The ETF Deathwatch list decreased in size in January. Ten exchange-traded products (“ETPs”) were added to the list, and 23 funds were removed. Of the removals, 17 were removed due to increased health and six were due to asset managers closing their funds. Equities continued to rise in January, so the decrease in the size of the Deathwatch list was to be expected.

The funds added in January were a mix of actively managed, international, and niche products. One fund was added because its assets under management (“AUM”) was consistently below $5 million for three months. The rest were added due to low average daily volume. These additions may have enough AUM to keep them from closure; however, our system takes into account both AUM and volume, so it’s likely that should volume and interest remain low, these funds may be considered for closure. The low volume in these funds could be due to the nature of the investment product. Many of the funds on the Deathwatch list are actively managed funds. Because equity markets have been strong recently, investors may be opting to stick with passive equity funds rather than actively managed funds and strategies that offer downside protection.

The addition of niche ETF products to the list wasn’t a surprise. The returns in the overall U.S. equity market have been strong, giving investors less reason to move money to actively managed and niche products. January has been rough for investors due to the outbreak of the coronavirus, fears of escalating tension between Iran and the U.S., and the impeachment trial of President Trump. Despite the overall negative sentiment at the start of January, U.S. equities continued their rally until the last week of January, when fears about the coronavirus increased. The fact that there were more removals from the Deathwatch than additions indicates January has been a strong month for markets. With so many negative headlines, it wouldn’t have been a shock for it to have been a little rougher for overall volume in ETFs. What we saw instead is that investors are still confident in this economic expansion.

Fifty-three ETFs and ETNs on the January Deathwatch list have been in the market for more than 10 years. This is a long time for ETPs to exist while remaining on our Deathwatch list. Leveraged and short ETF instruments, as well as a number of commodity ETPs, dominated our list of funds older than 10 years. It’s possible that the fund companies managing these products will allow them to remain active, as they may play a larger role for clients interested in active management.

The average asset level of the threatened ETFs on ETF Deathwatch decreased from $8.35 million to $8.01 million, and 66 products had less than $2 million in assets. The average age of products on the list increased from 50.53 months to 51.45 months, and the number of products more than 5 years of age remained at 131. The largest ETF on the list had an AUM of $25 million, while the smallest had assets of just $492,000.

Here is the Complete List of 468 ETFs and ETNs on ETF Deathwatch for January 2020 compiled using the objective ETF Deathwatch Criteria.

The 10 ETFs/ETNs added to ETF Deathwatch for January:

  1. ProShares UltraShort MSCI Japan (NYSEARCA:EWV)
  2. iShares Evolved US Consumer Staples ETF (BATS:IECS)
  3. Principal International Multi-Factor Core Index ETF (NASDAQ:PDEV)
  4. Principal US Large-Cap Multi-Factor Core Index ETF (NASDAQ:PLC)
  5. Principal US. Small-MidCap Multi-Factor Core Index ETF (NASDAQ:PSM)
  6. FlexShares Emerging Markets Quality Low Volatility Index Fund (NYSEARCA:QLVE)
  7. First Trust RiverFront Dynamic Asia Pacific ETF (NASDAQ:RFAP)
  8. Barclays Return on Disability ETN (BATS:RODI)
  9. ProShares UltraShort Basic Materials (NYSEARCA:SMN)
  10. Barclays ETF Linked to the S&P 500 Dynamic Total Return Index (BATS:VQT)

The 6 ETFs/ETNs that were closed:

  1. WisdomTree Dynamic Bearish U.S. Equity Fund (BATS:DYB)
  2. Virtus Glovista Emerging Markets ETF (NYSEARCA:EMEM)
  3. Cushing 30 MLP Index ETNs due June 15 2037 (NYSEARCA:PPLN)
  4. NYSE Pickens Oil Response ETF (NYSEARCA:RENW)
  5. WisdomTree CBOE Russell 2000 PutWrite Strategy Fund (BATS:RPUT)
  6. WisdomTree Balanced Income Fund (NYSEARCA:WBAL)

The 17 ETFs/ETNs removed from ETF Deathwatch due to improved health:

  1. AlphaClone Alternative Alpha ETF (BATS:ALFA)
  2. ProShares MSCI Emerging Markets Dividend Growers ETF (BATS:EMDV)
  3. First Trust S&P International Dividend Aristocrats ETF (NASDAQ:FID)
  4. LibertyQ Global Dividend ETF (NYSEARCA:FLQD)
  5. WisdomTree US Short-Term High Yield Corporate Bond Fund (BATS:SFHY)
  6. WisdomTree Fundamental US Corporate Bond Fund (BATS:WFIG)
  7. X-Links Monthly Pay 2xLeveraged Alerian MLP Index ETN (NYSEARCA:AMJL)
  8. AdvisorShares Focused Equity ETF (NYSEARCA:CWS)
  9. iShares US Dividend and Buyback ETF (BATS:DIVB)
  10. Direxion Daily Industrials Bull 3x Shares (NYSEARCA:DUSL)
  11. Global X MSCI SuperDividend EAFE ETF (NASDAQ:EFAS)
  12. Principal Millennials Index ETF (NASDAQ:GENY)
  13. iShares Evolved US Discretionary Spending ETF (BATS:IEDI)
  14. Defiance Quantum ETF (NYSEARCA:QTUM)
  15. Global X MSCI SuperDividend Em (NYSEARCA:SDEM)
  16. ProShares Ultra FTSE Europe (NYSEARCA:UPV)
  17. ProShares Ultra Industrials (NYSEARCA:UXI)

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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YINN: Sinking Under The Weight Of A Weak Yuan And Leverage Decay – Direxion Daily FTSE China Bull 3x Shares ETF (NYSEARCA:YINN)

The U.S.-China trade deal triumph seems like an ancient history now, as it took a mere 2 weeks to wipe out the months-long gains in the China large-cap ETF (FXI) and its 3x leveraged counterpart (YINN) in the wake of the coronavirus outbreak spiraling out of control. In fact, while FXI made a round-trip to roughly unchanged from a year ago, YINN actually suffered a -10% decline due to the leverage decay effect.

From a longer-term perspective, YINN collapsed by more than half its value even as FXI is down by only -9% since the beginning of last decade:

One interesting observation is that YINN actually had two separate 100+% moonshots in 2015 and 2017 during which its cumulative performance not only caught up but miraculously surpassed that of FXI. Indeed, leveraged bull ETFs enjoy the compounding effect rather than decay when the underlying benchmark is in an uninterrupted uptrend.

Quantifying The Compounding And Decay Effect Of Leveraged ETFs

Empirically, we notice in the above chart that YINN tends to diverge negatively from FXI during choppy and down markets, but significantly outperform in a strong uptrend. To measure the tenacity of an uptrend, we calculate the ratio between the average weekly up move and average weekly down move in FXI, the benchmark of YINN, over the past 24 weeks. In other words, the ratio would be 1.0 if the average magnitude of an up week equals that of a down week. Below we plot the ratio vs. the 24-week change in YINN’s price:

One crucial observation is that the 24-week price performance in YINN is negative during an FXI up/down ratio of 1.0, which can be explained by the leverage decay effect when its benchmark chops between ups and downs. Numerically, the expected loss is roughly -12% in YINN over a 24-week period when FXI ends up being unchanged:

On the other hand, when the up/down ratio increases towards 2 and beyond during persistent uptrends in FXI, the expected price change in YINN deviates from the linear trend due to the compounding effect. As such, we reckon buying YINN would be worthwhile only if there is strong conviction of a firm uptrend in FXI like in 2015 or 2017.

Choppy Waters Ahead In Chinese Stocks

Although Chinese stocks have staged a strong rebound since the market reopened after Lunar New Year, with the Shanghai Composite erasing losses from the epic -9% gap down, the relief rally is likely to be short-lived if history is any precedent. Specifically, when the Chinese flagship index:

  • Dropped more than 2% in consecutive weeks
  • Made 52-week highs but down in the last 3 months

More often than not, further turmoil would ensue in the Shanghai Composite, even though there may be sharp bounces in between. In terms of the implication on FXI, there is over 60% chance of lower lows still to come in the weeks ahead:

Date Shanghai Composite Last 2-Wk Chg Last 3-mo Chg Last 52-Wk Chg FXI Forward Chg 2-Wk 4-Wk 12-Wk 24-Wk
11/25/2007 4,872 -8.36% -6.65% 147.07% 57.43 9.93% 3.34% -13.01% -11.77%
1/20/2008 4,762 -13.18% -17.59% 78.47% 52.31 -3.98% -4.50% -8.95% -19.94%
3/16/2008 3,797 -11.72% -27.84% 29.55% 42.96 6.22% 10.89% 9.85% -1.97%
9/27/2009 2,779 -6.18% -10.74% 33.94% 41.23 4.03% 7.59% 0.65% 0.02%
1/24/2010 2,989 -7.28% -5.52% 50.17% 39.07 -3.84% -0.10% 8.29% 4.12%
4/25/2010 2,871 -8.30% -3.97% 17.24% 42.05 -9.06% -9.13% -7.87% 5.59%
6/28/2015 3,687 -17.67% -8.61% 79.03% 46.21 -7.47% -9.67% -21.47% -25.28%
8/23/2015 3,232 -18.48% -35.65% 45.79% 36.56 -8.15% -0.74% 1.56% -18.68%
2/2/2020 2,876 -6.49% -2.98% 10.54% 39.74
Average -1.54% -0.29% -3.87% -8.49%
Median -3.91% -0.42% -3.61% -6.87%
% Positive 37.50% 37.50% 50.00% 37.50%

Yuan Expected To Be Pinned Near The Lows

Meanwhile, a lower yuan is another reason why bounces will likely be anemic in the Chinese ETFs, given the USD/CNH has been highly correlated with FXI and YINN’s performance in the past 5 years:

With the Chinese economy crippled on multiple fronts by the ongoing coronavirus outbreak, the path of least resistance of its currency is most likely to be down in the face of PBOC’s aggressive easing policies to cushion the negative impact. To wit from New York Times:

China’s central bank unexpectedly cuts some key short-term money market interest rates, and analysts predict more are likely. A central bank adviser says the possibility of a cut in the country’s benchmark loan prime rate (LPR) on Feb. 20 has significantly increased.

While lower interest rates will certainly give the economy a much-needed boost, it will most likely take a toll on the banks, which make up a large percentage of FXI’s exposure. As discussed in the previous article on the fundamental outlook of FXI, the dismal earnings growth in financials will most likely continue to dampen its upside potential.

Furthermore, the commitments set in the recently signed U.S.-China trade deal with regards to competitive currency devaluation will most likely to take a backseat, as “analysts said that Beijing may now be tempted to allow the yuan’s exchange rate to gradually depreciate to support exports in the coming weeks.” according to SCMP.

Therefore, due to the fact that currency exposure in FXI and YINN is unhedged, a weakening yuan will most likely offset any potential gains in the domestic stock market. All in all, we anticipate FXI to whipsaw towards lower lows, and in turn lead to more profound underperformance in the YINN resulting from leverage decay.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: We may have options, futures or other derivative positions in the above tickers mentioned.

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