SET Monthly Issue February 2014

| February 18, 2014

February 2014


I’m sure you’ve noticed that some of the economic data hasn’t been as good as expected.

In fact, the correction in January can be attributed at least in part to weaker retail sales and employment data.

Some investors jumped to the conclusion that the slow pace of economic growth was slipping and the economy would fall back into a recession.

Here’s the thing, most of the slump in economic activity can be attributed to the extremely cold weather hitting large portions of the country.

What’s more, the idea that the economy is growing slowly is flawed.

The private economy is growing at a healthy 3.45% per year.  The reason economic growth is seen as being slow is government spending and investment is shrinking at a rate of 1.69% per year.

Right now, government spending and investment accounts for 17.98% of the economy.  That’s down from 21.61% in July of 2009.  And it’s the lowest ever recorded since the data was first recorded in 1947.

In other words, the slowdown in government spending is a huge drag on the economy.

And that’s not the worst part…

The number of people employed by all levels of government has shrunk considerably. In December 2009, 16.29% of people held jobs from the government.  Today only 15.13% are employed by the government.

I’m only speculating here, but don’t you think it’s odd that long term unemployment and shrinkage in the labor market are rising at the time when people are getting kicked out of their government jobs?

Maybe the pension and retirement packages for government employees losing their jobs are a little too good.  Or maybe they’re finding they’re not qualified to do much in the real world.  But I digress…

The point is, the private sector is creating jobs. But the job losses created by public policy have kept the unemployment higher then we typically see at this point in the economic recovery.

Here’s the bottom line…

The private economy is better than you think it is.  It’s growing fast enough to make up for the drop in government spending and still generate 2.34% US Real GDP growth.

And don’t forget, we could be nearing a turning point for government spending. Spending at the local, state, and federal levels could stop shrinking this year.  And looking back over history, investors are usually bullish on stocks when the government stops being a drag on the overall economy.


Not too long ago everybody hated financials.  The feelings of hatred were so pervasive that the ‘Occupy Wall Street’ movement was mainstream.

Many investors were ashamed to admit they owned financials.

But the mood toward banks has dramatically improved over the last few years.  That’s not to say that financials are universally loved, far from it, but the hatred has subsided to the point that investing in the sector can be done without feelings of shame.

This is so important because banking, unlike most businesses, is a business of confidence.  People must have confidence in the banking system for it to operate.

The changing mood toward financials creates an opportunity for financial stocks to outperform in the weeks and months ahead.

Macro/Economic Trend:  Below Normal Profitability

And it’s not just the improving perception of financial companies.

Lately, many financial institutions have taken steps to deal with past transgressions. The settlement of mortgage claims and other legacy issues clears the way for banks to focus on the future.

What’s more, the return on equity for financials is running below what we’ve seen over the long run.  The current ROE for US financials is 8.8% today.  That’s 2.8% below their 30-year average of 11.6%.

Much of this gap can be attributed to two main causes – extremely low interest rates and changing regulatory environment.

Today, financials are on the path towards ROEs returning to the norm. I’m expecting net interest margins to expand, trading volumes to grow, and fee income to increase.

As we’ve seen many times throughout history, as regulations become more certain, companies adapt to restore profitability. Yet, today the valuations of banks and many other financials reflect an inability to change.

I believe this perception is flat out wrong. Financials will adapt and adjust their business so that profitability will be restored.  And when it happens, financials could go on an epic run as investors catch up to the improving fundamentals.

The ETF I like to profit from the improving ROE is the Financial Select Sector SPDR Fund (XLF).

Fundamentals:  A closer look at XLF

XLF currently holds 83 stocks.  It tracks a market-cap weighted index of financial stocks in the S&P 500.

The expense ratio is 0.16%.  And it has a dividend yield of 1.52%.

The top five holdings and percentage weight for XLF are –

Company Name Ticker % Weight
Wells Fargo WFC 8.38%
JPMorgan Chase JPM 8.29%
Berkshire Hathaway Class B BRK.B 7.84%
Bank of America BAC 6.75%
Citigroup C 5.69%

Technicals:  The charts lead the way

XLF is currently trading for $21.68.  It’s up 28.5% from the 52-week low and 2.1% below the 52-week high.

As you can see in the chart below, XLF has been trending higher over the last year.  It recently fell back to support (green line) and bounced back quickly.


Over the last few years, this pattern that has led to new highs for XLF.  And I’m expecting it to repeat itself again this time.

In short, XLF is in a stable, long term uptrend.  And expect this pattern to continue going forward.

Trade Alert

Buy:  Financial Select Sector SPDR Fund (XLF) up to $22.25
Recent Price:  $21.68
Price Target:  $29.00
Stop Loss:  $20.00

Remember:  XLF has been in a steady long term uptrend.  But the current expectations of lower ROE has held financials valuations in check.  As businesses adjust and adapt to the new regulations, I’m expecting ROE to move higher and justify higher valuations for financial stocks.


Consumer Discretionary (+0.1%)

Consumer Discretionary had a roller coaster ride over the last month.  They dropped quickly after our last issue and bounced back to essentially the same level they were a month ago.

Different industries within the sector have driven strong performance from one year to the next.  I like the exposure we have to consumer discretionary industries with our three current holdings.

iShares US Home Construction ETF (ITB) reached a high of $25.39 today… the highest level since last June.  However, it was short lived.  A report today showed homebuilder confidence plunged to a nine month low in February.  The main culprit was weak sales trends due in part to the extremely cold weather conditions.  These conditions should be short lived.  And the spring selling season could be the best since the house bubble burst.  Continue holding.

PowerShares Dynamic Media Portfolio (PBS) is bouncing back after a rough start to the year… since February 3rd, PBS is up 7%.  Media stocks should continue to perform well as the economy improves.  Continue holding.

PowerShares Dynamic Leisure & Entertainment Portfolio (PEJ) has bounced back quickly from the January selloff.  It’s within 1.3% of the 52-week high.  These economically sensitive stocks stand to benefit from faster economic growth in the months ahead.  Continue holding.

Consumer Staples (-0.5%)

Consumer staples have been slower to bounce back from the market correction.  The sector is still 3.6% below the 52-week highs.  However, our First Trust Consumer Staples AlphaDEX Fund (FXG) has bounced back quicker.  It’s only 1.6% below it 52-week high.  As I’ve pointed out before, FXG is uniquely positioned as a consumer staples ETF with growth potential.  Grab your shares up to $36.00.

Energy (0.0%)

Energy stocks continue to lag behind other economically sensitive sectors.  The sector is being weighed down by lower oil prices.  Slowing demand and increasing global supplies of oil are strong headwinds for oil and oil dependent stocks to overcome.

Alternative energy stocks continue to be the place to be in the energy sector.

Our Guggenheim Solar ETF (TAN) is hitting new 52-week highs today.  It’s up 26% from where we recommended it in December.  Our First Trust Global Wind Energy ETF (FAN) isn’t doing too shabby either with a 22% gain so far.

I remain extremely bullish on FAN and TAN. Continue holding…

Our Morgan Stanley Cushing MLP Hi Income ETN (MLPY) has been rock steady throughout the down turn.  Our total return including dividends is 8.5%.  Feel free to buy MLPY up to $18.50 if you don’t already own it.

Financials (-1.3%)

Financials have been a disappointing lately.  But the recent underperformance is a great buying opportunity.  As I explained in the trade alert, the opportunity for financials to adjust to the new regulatory environment and increase ROE bodes well for the sectors performance in the months ahead.  I’m recommending the Financial Select Sector SPDR Fund (XLF) this month… see Trade Alert for details.

Our First Trust NASDAQ ABA Community Bank Index Fund (QABA) is up 10%, but it remains well below the recent highs.  However, it should bounce back in the coming weeks.  Continue holding.

Healthcare (+2.1%)

Healthcare was one of top performing sectors over the last month.  Our Health Care Select Sector SPDR (XLV) shot out to a new high.  It hit our $57.50 price target on February 11th.  That’s our cue to take our 19.5% profit.  Congratulations on a successful trade.

Industrials (-0.9%)

Industrials have been slower to bounce back than some sectors.  Clearly the higher level of uncertainty about the global economic outlook is weighing on the globalized sector.  And the 0.3% drop in industrial production in January isn’t very reassuring.

Our iShares Transportation ETF (IYT) has been slow to rebound from the selloff. However, we’re still up 11.5%.  Needless to say, transportation plays a vital role in the global economy.  And it should resume its leadership position once we get some clarity about the global economy.  Continue holding…

Technology (+0.9%)

The technology sector is on the upswing. It has recouped all the losses and is back at 52-week highs.  Our Guggenheim S&P 500 Equal Weight ETF (RYT) equal weighted ETF is performing even better.  Don’t forget to keep an eye on the RYT as we near our $80.00 price target…

Materials (+0.4%)

Materials are having one of the strongest performances since stocks bottomed on February 3rd.  The sector’s performance is being bolstered by solid earnings reports from several companies.  We could see tailwinds for this sector again this year.

Utilities (+5.8%)

Utilities have seen a nice uptick due to the cold weather sweeping through the US. Utilities output surged 4.1% in January thanks to increased heating demand.

Portfolio Changes

  • This month we’re buying XLF.
  • Sell XLV for a 19.5% gain.


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