Is It Time to Buy Our Reflation Basket, September 21, 2017

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Trading Color and Bottom Line: Is It Time To Allocate to Our “Reflation Basket”?

There’s a simple question that we need to address following the Fed’s hawkishly interpreted announcement: “Is it now time to rotate out of defensives (super-cap internet, healthcare, utilities, staples) and into cyclicals/reflationary sectors?”

I bring this up for two reasons.

First, getting this rotation right was the key to outperforming in 2016, and I don’t think it will be different this year. Second, there are growing signs that it may be time to make this tactical rotation.

Looking at the sector trading yesterday, it was a classic “reflation rotation.” Tech, utilities and consumer staples (sectors that have outperformed YTD) all lagged the market while cyclical sectors (which have badly underperformed) rose. Meanwhile, banks surged 1.1%, energy rose 0.35% and industrials gained 0.73%, while consumer discretionary rallied 0.34%. Additionally, small caps (which have been laggards YTD but are playing catch up in a hurry), rose 0.35% and the Russell 2000 was again the best-performing major index.

So, to answer the question of whether we need to begin to rotate into these cyclical sectors, I believe the answer depends on your time frame.

For medium- and longer-term investors, I continue to believe the answer is “no,” or at least “not yet.”
However, for short term oriented, tactical traders/investors, legging into some reflation/cyclical sectors at
these levels could make sense.

For medium and longer term investors/advisors, I’m looking for two key indicators to tell me when to rotate
into cyclicals.

First, I want to see the bank index ($BKX) hit a new high for the year. That means trading above $99.77, and closing above $99.33 (so call it 100 to make it easy).

Second, I want to see 10-year yields close above 2.40% (currently 2.28%).

If those two signals are elected, then for medium- and longer-term advisors/investors, I would advocate booking (large) profits in healthcare (XLV/IHF/IBB), super-cap internet (FDN), consumer staples (XLP) and utilities (XLU).

And, I would advocate allocating those dollars to our “Reflation Basket” we introduced earlier this summer: KRE/KBE (bank exposure), XLI (global industrials), IWM (small caps), TBT/TBF (short bonds). Additionally, I view yesterday’s price action as position for European financials and EUFN specifically.

Again, for those investors who are nimble and can stand some pain, establishing positions now does make some sense. But, for the remainder (again medium– and longer-term investors) I’d wait until those two indicators (BKX and 10-year yield) have been elected.

Regardless, we are witnessing a potential sea change in the outlook for central bank policy, and that’s going to require more vigilance on the part of advisors and investors.

If the global rate-hike cycle is now underway, then the proverbial hour glass just got flipped and the sand is now running out on the eight-year bull market (more on that in tomorrow’s issue).

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