A Hawkish Thanksgiving

Friday’s Payroll report offered investors the one Christmas present they’ve wanted for over a year, certainty, as the strong job growth and increase in hourly earnings convinced all but the most dovish economists that the time has come to raise interest rates.  The S&P 500 suffered a case of accelerated sector rotation on Friday thanks to the rapid repricing of risk as the Fed Fund futures now price in a 70% chance of a hike next month.  However, even as it recovered most of the losses suffered at the open, the day ended with a wide gap between the best and worst performing sectors that could signal the shape of things to come (at least until after the Fed pulls the trigger.)

It shouldn’t come as any surprise to our readers that the biggest winners on Friday were those funds devoted to smaller regional banks that stand to benefit the most from rising rates including the PowerShares KBW Bank Portfolio (KBWB), the PowerShares KBW Regional Bank Portfolio (KBWR) and the First Trust NASDAQ  ABA Community Bank Index Fund (QABA) all of which had returns in excess of 2.5% and with all three finding a home in our list of Top 100 Behavioral Scoring Funds.  In fact, thanks to its focus on micro and small cap names, QABA has risen all the way to the sixth spot on the list while delivering a 2015 return of 15.4%.  Bank funds were hit hard last summer thanks to waning momentum as investors began to despair over rates ever rising again and they continued to lag after September’s FOMC meeting.  October was much kinder with the funds but if you’re wondering why you haven’t seen them on a list of top ETFG Quant movers before now, it’s because their behavioral scores have been steadily rising over the last few weeks as investors began to readjust their internal playbooks to the possibility of a rising rate environment while correspondingly punishing those domestic sectors most likely to suffer the worst fallout when rates begin to rise.

If the old market adage, “buy the rumor, sell the fact” continues to hold true, financials could enjoy stronger performance at least until the next FOMC gathering, but before you hit the buy button, consider how far we’ve come already.  For many funds, Friday’s big gains were just the icing on the cake with QABA up 6.73% and fellow small-cap player KBWR up 7.48% for the week and both up double digits for 2015!  And for those investors who like to consider the long-term view through the lens of fundamentals, those heady gains have translated into very rich valuations.  In fact, if you reorder the ETFG Quant tables by their fundamental scores, QABA and KBWR would rank as the 40^th and 41^st most highly priced funds (relatively to their prior price history) respectively which offers more insights into why KBWB saw such a strong increase in its behavioral score.  Not only was the fund not as richly priced but it has been lagging the smaller funds due to its focus on larger cap names although it is more highly concentrated, with just 24 holdings, than the Financial Sector Select SPDR (XLF).

Of course you can’t have winners without losers and with the exception of the gold miners (who seem born for pain) no one suffered as much last Friday as the utilities with the Utilities Sector Select SPDR Fund (XLU) down nearly 3.5% on the day.  Having seen nearly all of its September gains eroded over the last three weeks, many wonder why the utilities have lost so much ground and so quickly.  Traditionally a defensive sector, their recent underperformance is due in no small part to the market’s increasing certainty on the timing of the Fed’s first rate hike, but while the market hates uncertainty more than anything, there’s more at play than just improving sentiment.  When Treasury yields are below a certain level (5% according to J.P. Morgan’s Guide to the Markets) there is a well demonstrated, positive relationship between Treasury yields and stock prices so as yields rise (and bond prices fall), equity prices should as well.  Historically, the utilities sector has a negative correlation with changes in Treasury yields, so the price of XLU and other utility funds could have further to fall as rates continue to rise in anticipation of future hikes.  Not helping the situation is the nature of the funds in the space; XLU is highly concentrated with just 31 holdings as well as market-cap weighted with 60% of the assets in the top ten names.  Compare that with the Guggenheim S&P 500 Equal Weight Utilities ETF (RYU) which has many of the same names but its equally weighted allocation offered much better downside protection with the fund down 1.58% over the last month compared to XLU’s 3.12% loss.

No matter which way your investing inclinations lie, the markets will be entering a brave new post-ZIRP world in the near future and your portfolio will have to adjust accordingly.

Thank you for reading ETF Global Perspectives!

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