Is a Reversion Setting Up in the “Risk On” Trade?

• stevenplace
• May 18th, 2011

The Ugliness is Hidden

I’ve argued over the past few weeks that the drawdown in equities really hasn’t been that bad, but underneath the surface the market has seen some significant liquidation out of high beta and “global growth” themes, and a rotation into safer, defensive bets such as staples, healthcare, and utilities.

We’re coming to a point in which this relationship is getting a little stretched. Of course it comes back to the dollar, the carry trade, and the run in commodities so any sort of re-rotation back into materials would need some currency tailwinds to help the trade.

Watch this Pairs Trade

The simplest way to view this relationship is to compare the SPDR Materials ETF ($XLB) with the SPDR Consumer Staples ETF ($XLP). When we see a strong risk appetite, that means the “global growth” trade is on and materials will outperform. When there is a tempering of risk appetite, rotation into safer plays will be the norm.

Let’s compare the relative performance of these two, to see exactly how stretched this trade has become:

After a pretty clear breakdown, this relationship has become a little stretched. There is no clear cut “this is the bottom” trade, but it’s more of a feel of exactly when we should see capital rebalances.

Watch Your Calendar

So the market is coming into opex, and then the end of the month. If we see any weakness in the dollar, portfolio managers may reallocate capital back into materials, which leads to yet another “me too” trade and leads to some chasing on the intermediate term.

If this reversion does occur, it doesn’t mean the trend will all of a sudden change– if the market rolls expect defensive names continue to outperform. But as for right now, I feel it’s best to stay away from defensive names for better entries and play for a bounce in risk.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

Tickers: xlb, xlp

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