Reading a sector ETF, and the credit cycle

Two shortcuts finish the macro module. A sector ETF compresses a whole industry's fundamentals and flows into one chart, so you can see whether a stock is moving because of itself or because of its neighbourhood. And the credit market, which prices the risk that companies cannot pay their debts, tends to notice trouble before the stock market does.

Why sector matters so much

Studies attributing stock returns to their sources consistently find that a large share of an individual stock's movement over weeks and months is explained by the market and its sector, with the stock's own news explaining the rest. The exact split varies, but the message is stable: a stock that is up 8% in a month in a sector that is up 9% has done nothing on its own. A stock up 8% in a sector down 3% is telling you something.

For the trader this is the difference between a real fundamental signal and a tide. Module 4's beat-and-raise in ACME is much more meaningful if industrials are flat than if industrials are up 10% and every company is beating.

Reading a sector ETF in five checks

Sector exchange-traded funds hold a basket of the sector's stocks. Their charts, holdings and flows are free. Five things to read:

1. Absolute trend. Is the sector ETF above or below its 50 and 200-day moving averages, and are those averages rising? Same method as the index regime check in the swing trading playbook, applied one level down.

2. Relative strength. Divide the sector ETF's price by the broad index's price and chart the ratio. A rising ratio means the sector is leading. Sector leadership tends to persist for months, and rotations between sectors are among the most reliable medium-term trends in the market.

3. Breadth within the sector. What percentage of the ETF's holdings are above their own 50-day average? A sector ETF at new highs with 40% of its members below their average is being carried by a few large names. That is fragile.

4. Concentration. Many sector ETFs are dominated by two or three giants. If the top three holdings are 45% of the fund, the "sector" chart is really those three stocks. Check the holdings before treating the ETF as a proxy for a mid-cap member.

5. Flows. Some data providers publish weekly fund flows by sector. Money moving into a sector ETF is the institutional rotation from module 5's 13F discussion, but in real time.

A simple scorecard for ACME's sector before a trade:

Neutral to mildly positive. ACME's beat-and-raise is not being helped by a sector tailwind, nor fought by a headwind. Its drift trade stands on its own.

Key idea: Chart the sector ETF's ratio to the index. If the ratio is rising, longs in the sector have a tide behind them; if falling, they are swimming against it. Check concentration before trusting the ETF as a proxy.

Using the sector as a filter

Add "sector ETF above its 50-day and ratio to index not falling" to the checklist for longs, and the reverse for shorts. It removes trades that fight the rotation. (Traders who like a company but not its sector sometimes short a little of the sector ETF against the long, isolating the stock's relative performance; that is optional and beyond most swing plans.)

The credit cycle

Companies borrow. The price of that borrowing, and the willingness of lenders to extend it, moves in a cycle that is closely tied to the economic cycle and often leads the stock market at turns.

The key gauge is the credit spread: the extra yield that corporate bonds pay over Treasuries of the same maturity. Investment-grade spreads (for companies like ACME) might be 1 to 2 percentage points in calm times; high-yield spreads (for levered companies like ACME Heavy) might be 3 to 5 points in calm times and 8 to 20 in a crisis.

Why it leads: bondholders only care about getting paid back, so they are the first to notice when a company's ability to pay is slipping. A stock can rally on a growth story while its bonds are quietly being sold; when the two disagree, the bonds are more often right.

What a trader watches

• A high-yield bond ETF's price and its ratio to a Treasury ETF. Falling ratio means spreads are widening. Free to chart.
• The high-yield spread itself, published by central banks and data providers. Its direction over the last month matters.
• Central-bank surveys of lending standards, quarterly, asking banks whether they are tightening or loosening. A slow but powerful leading indicator.
• A specific company's bond price if it is levered. If ACME Heavy's bonds trade at 80 cents on the dollar, the credit market thinks there is a real chance of default, and the equity is an option.

For ACME itself, with investment-grade debt and coverage of 10 times, the credit cycle mostly matters through its customers and its multiple. For Heavy, it is everything. The fundamental filter from module 1 (debt/EBITDA under 4) is, in the end, a rule that says: do not own the stocks the credit cycle will hit first.

Try it: Chart a high-yield bond ETF divided by a Treasury ETF over five years, and below it a broad stock index. Find the periods where the ratio turned down before the index did. Then chart your favourite sector ETF divided by the index and mark the last three rotations into and out of it.

Recap

• A large share of a stock's move over weeks and months comes from its sector and the market; measure the stock against its sector before crediting its own news.
• Read a sector ETF by trend, relative strength ratio, internal breadth, concentration and flows.
• Use the sector ratio as a filter for longs and shorts so you are not fighting the rotation.
• Credit spreads price the risk of not being repaid and tend to widen before stocks fall; levered companies feel the credit cycle first.
• The debt limit in your fundamental filter is a rule for avoiding the stocks the credit cycle punishes first.