Should you hop on the reflation train?

Mid-week market update: About two weeks ago, I identified an emerging theme of a rotation out of large cap growth stocks into cyclicals (see Sector and factor review: Not your father’s cycle). The latest BoA Global Fund Manager Survey (FMS) confirms my analysis. The rotation is attributable to managers buying into the reflation trade.


Does that mean you should hop on the reflation train? Is there sufficient momentum behind this shift?

Growth expectations revival

Actually, the shift into the reflation trade is mis-named. It’s not that inflationary expectations that are rising that much, but growth expectations.


The growth to cyclical rotation can be seen in regional weightings. For several months, managers had been piling into US equities as the last source of growth in a growth starved world. The FMS had shown the US as the top weight in equity portfolios for some time. In the latest survey, the top regional overweight is now the eurozone, as managers have latched onto the reflation and cyclical theme.


A cyclical report card

How are cyclical stocks are performing. First, it’s unclear how well the rotation into eurozone equities will work out. High frequency data shows that the recovery is stalling on the Continent.


In the US, the relative performance of cyclical stocks presents a mixed picture. While homebuilding stocks are on fire, the relative performance of other cyclical sectors and industries show constructive but limited signs of market leadership. Material stocks are turning up relative to the market, but industrial, transportation, and leisure and entertainment are only exhibiting bottoming patterns.


I have made this point before, this is not a normal economic cycle and interpreting it that way can bring trouble for investors. Instead of a normal Fed induced slowdown, the global economy encountered a pandemic driven sudden stop. The pandemic is still ranging all over the world, and the recovery in demand will depend mainly on how well the human race can control the COVID-19 outbreak. Therefore the recovery will not follow the normal patterns of past economic cycles (see Sector and factor review: Not your father’s cycle).

I believe that equity risk and return are asymmetrically tilted to the downside. Conventional sector and factor analysis is pointing towards a rotation out of US large cap growth stocks into cyclical and EM equities. However, this is not a normal cycle and many of the usual investment rules go out the window. Historical analogies are of limited use. This is not 2008 (Great Financial Crisis), 1999 (Dot-com Bubble), 1929 (Great Depression), or 1918 (Spanish Flu).

Investors have to consider the bearish scenario that a rotation out of US large cap growth does occur because of a crowded long positioning, but the rotation into cyclical and EM does not occur. Instead, the funds find their way into Treasuries and other risk-off proxies because of either the failure of early vaccine trials, or teething problems with deploying vaccines and therapeutics. In that case, the growth path falls considerably from the current consensus, and a risk-off episode and valuation adjustment follows.


Focus on risk, not return

Under these conditions, investors are advised to focus first on risk, than return. Mark Hulbert observed that his Hulbert Stock Newsletter Sentiment Index is higher than 95% of all daily readings since 2000. That’s a crowded long condition, which is contrarian bearish. While the market can continue to advance under such conditions in the past, intermediate term risk and reward are not favorable for equity investors.


In the short run, the NASDAQ leadership remains intact. While the 5-day RSI continues to flash negative divergences for the NASDAQ 100, the index has shrugged off these warnings and continued to rise. Until we see signs of trend breaks, either on an absolute or market relative basis, it would be premature to be bearish.


The market can continue to grind higher in the short-term, but investors who focus on risk and reward are advised to be cautious. There’s probably turbulence ahead.


24 thoughts on “Should you hop on the reflation train?

  1. That is perceptive. The lack of yield control means that medium and long dated treasuries will get more attractive as the stock market rises. Worth watching TLT closely.

    1. Just shows what a dishonest press can make people believe.”

      “Six months into this pandemic, Americans still dramatically misunderstand the risk of dying from COVID-19:

      • On average, Americans believe that people aged 55 and older account for just over half of total COVID-19 deaths; the actual figure is 92%.

      • Americans believe that people aged 44 and younger account for about 30% of total deaths; the actual figure is 2.7%.

      • Americans overestimate the risk of death from COVID-19 for people aged 24 and younger by a factor of 50; and they think the risk for people aged 65 and older is half of what it actually is (40% vs 80%). ”

      “These results are nothing short of stunning. Mortality data have shown from the very beginning that the COVID-19 virus age-discriminates, with deaths overwhelmingly concentrated in people who are older and suffer comorbidities. This is perhaps the only uncontroversial piece of evidence we have about this virus. Nearly all US fatalities have been among people older than 55; and yet a large number of Americans are still convinced that the risk to those younger than 55 is almost the same as to those who are older.”

      1. Covid risk is actually more like lung cancer or heart attack risk. But this misunderstand results in policies where everyone receives chemotherapy. It’s no wonder there is non-compliance, controversy or people who claim we must do nothing different at all.

    1. I suppose they are already there, D.V. The 10 year Treasury is at 0.65% and I think inflation is somewhere between 1%-2%.

      If yields fall further and inflation rises Utilities should benefit and hard assets like gold, silver, platinum, oil and companies with other hard assets still in the ground.

  2. It feels like the formation of a proper top-

    (a) Indexes are not heading straight down – in which case traders would be buying the dip.

    (b) The so-called rebalance trade (eg, banks and energy) is fading, while the momentum trade continues to buoy the indices.

    (c) The decline may take a few weeks to develop, and hopefully accelerate into a selling panic that then becomes the next buying opp.

    That’s my rough guess at this point.

    1. I’m not so sure your assumption from the other day may play out. We take a little dip off the S&P high and that Fib line I mention then we power up through it. A lot of that is conditional on the news relating to the virus and the economy continuing to show some recovery.

      Of course, Sept./Oct. are months to be wary of.

    1. Is that a day trade? Holding a leveraged fund near an all-time high over the weekend will be challenging.

      1. RX, here is my thinking about trading leveraged funds vs nonleveraged funds. This comes from my futures trading years.

        Just for round numbers, suppose I would normally take a short term trade with a $100,000 position in a stock or index. If I’m going to use a 3x leveraged fund I would only take an approximately $33,000 position. I basically have the same size as my normal trade (hence the same dollar volatility) but committed less of my capital. I do realize that there is some wasting asset disadvantage to a leveraged fund so I only consider them for short term trades.

        The only thing I don’t like are the low priced leveraged funds like the approximately $5 SPXU. The trading account in my 401K makes me enter orders at a penny. But, the funds actually trade at 100th of a penny. And, I’ve noticed traders step in front of my orders at my price plus a couple hundredths of a cent. So, I may miss a trade because I can’t place my order at hundredths of a cent and on very low priced funds that matters when it is a short term trade.

        1. For the heck of it, I bought 1000 shares of SPXU at market ~3 pm, and it filled @ 8.77058/share – so you’re correct that it trades at hundreths or even thousandths of a cent. I’m not guy who likes to short, but at that position size and at these levels I have absolutely no anxiety about holding the position through Monday.

  3. My ‘tells’ re the market> as of right now, SPY/ IWM/ XLF/IJS/ RPV/ XLE are -0.13%/ -1.74%/ -2%/ -2.8%/ -3%/ -4% below my exits ~730 am (pst) on Wednesday. And I have no interest in reopening any of the positions here.


    The aftermanth of last Sunday’s phenomenal display of lightning strikes. I recall being wakened by thunder around midnight, and then walking the dog six hours later in the hills amidst flashes of lightning across the Bay.

    My younger brother owns property in Healdsburg (Sonoma County), which has been threatened by wildfires three years in a row. As of right now, the Walbridge Fire has spread to an area just south of the city.

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