Day Hagan Research Update




Money flows into major style, sector and capitalization ETFs can highlight where institutions are allocating their money.


Neil Leeson


March 3, 2017


As I have mentioned in previous blogs, over the course of significant market declines, investors typically will rotate into defensive sectors and stocks that are considered fundamentally strong. I did a study a few years ago comparing the returns of sector funds during the first, second and third segments of bull and bear markets. I found that, historically, in the last third of a bull market, fundamentally based sectors and capitalization-weighted sectors (large cap proxies) evidenced the largest outperformance while equally weighted sectors (often used as small cap stock proxies) fell behind. Additionally, in the last third of bull markets, defensive and income-oriented sectors typically outperformed growth and cyclically sensitive sectors, across all weighting (cap-weighted and equally weighted) schemes.

Yet, in the first third of bear markets, equally weighted sectors (small cap proxies) typically outperformed while fundamentally oriented defensive sectors lagged.

While I am not calling the end of this secular bull market, there are signs that investors are rotating into sectors and styles that typically do well in the late stages of prolonged up moves, which is worrisome. This may be occurring for multiple reasons, including profit taking, extreme sector sentiment, "forward valuations priced for perfection" and so forth.

In my view, this rotation began last week and continued early into this week—until the President's (optimistic) address to Congress on Tuesday evening. However, when the market opened on Wednesday (including pre-market trading), investors piled back into the "Trump trade." But there was little follow through on the "Trump trade" on Thursday, as the defensive sectors outperformed once again. Again, worrisome, but not anywhere near a death knell for the markets. More likely a "caution sign" of speed bumps ahead.

One indicator I follow on a daily basis is the flows into ETFs. These flows, provided by Ned Davis Research Group, are calculated by taking the net value of redemptions and creations of ETF shares on a given day. Unlike mutual funds, ETFs can create and redeem shares throughout the day, typically in blocks of 50,000 shares, and are typically done by larger institutions. (One caveat to this data is that shares can be created to go short, so I also monitor the short interest in a fund.)

As shown in the table below, in aggregate over the past five days, investors have been net redeemers in several of this year's top performing sector funds (Technology, Industrials and Financials) and have been net purchasers in more defensive areas of the market like Consumer Staples and Utilities. Near-term return figures compared to longer-term return figures also suggest an underlying shift might be occurring.

Flows into individual sectors are very telling, especially when one aggregates flows into all long-only non-leveraged ETFs in a particular sector, style, country or capitalization. Using this method, the message can be clearer and more powerful. As shown on the chart below, after several months of net outflows from domestic Utility sector ETFs, money started to flow the other way in February.

An aggregated chart of flows into domestic Consumer Staples ETFs illustrates a very similar picture. These are not the type of flow charts you would expect to see in a highly optimistic market where investors are actively seeking risk and chasing outsized returns. Investors seem to be repositioning into fundamentally strong defensive sectors.

Money flows are not only alerting us to a possible rotation in investor allocation, they are also an indication of a possible change in investor sentiment. Below is a chart of flows in and out of Industrial sector ETFs, which showed net outflows of $43.9 million in February. This is a small sum given the total assets in Industrial ETFs, but it is the first indication that attitudes may be changing. (There is a barely visible red line at the bottom of the third clip.)

In addition to positive flows into Utilities sector ETFs, we have seen a big shift in sentiment towards the underlying stocks that make up XLU, the Sector SPDR Utility fund. In fact, it has now reached extremes where historically the returns had been negative twelve months later.

Even though there are currently positive money flows overall and stong indications that investors are excessively optimistic, we would note that forward earnings, even though off of recent highs, still suggest that stocks in this sector are priced for perfection (next chart). Surprisingly, investors may be heading to defensive sectors that may not offer the longer-term protection that they think they are getting. Based on forward multiples, this is a sector we are not considering at this time.

Like Utilities, the forward P/E multiples for Consumer Staples stocks also illustrate investor/analyst optimism. So despite positive flows and supportive sentiment, it is difficult for us to warm to this defensive group.

Oddly enough, the current market action suggests there is a shift underway to sectors that have historically been more defensive in nature because they have often represented value and consistency, but that those same sectors are now being shadowed by extreme optimism and expensive valuations. This may suggest that for those defensive companies to continue to appreciate, they will have to meet and exceed analysts' expectations.

At this juncture, in our opinion, investors may be exiting one set of perceived higher risk sectors, but ending up entering another high risk situation. Therefore, you will not see us rotate or take a defensive sector posture with our cash exposure at this time. We would rather continue to own the growth/cyclical side of the market on declines (as we explained last week), given that their longer-term potential to meet or exceed expectations is more likely in the current economic, monetary and political environment.

Nonetheless, watching ETF flows, sector performance and sentiment provides us with valuable information into investor positioning.

Have a wonderful week,

Neil Leeson
Day Hagan Investment Committee Consultant
Day Hagan Asset Management

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