DAILY STRATEGY: Our call is for the 10yr yield to grind sideways in a 4.2-4.5% range (HERE). That implies some downside skew from current levels. A continued economic expansion with 10yr yields in the 4.2-4.5% range favors fundamental factors (Earnings momentum, GARP, Growth, Value), Cyclicals, and AI Capex beneficiaries. Some AI beneficiaries are correcting now as the Price Momentum factor corrects.
FYI – We would look to add to the AI capex beneficiary baskets AFTER the volatility of the Price Momentum declines (HERE). High single-stock implied volatility (99th percentile) and accelerated turnover rates in the price mo factor suggest a heavy influence from retail “swarming” and momentum chasing. Some of the “chasing” in momentum stocks is unwinding now as 10yr yields decline. Recall that the Price Mo factor tends to do well when 10yr yields move above 4.5% (HERE). Economic growth expectations decline when 10yr yields move above 4.5% (demand destruction odds increase). Price Momentum stocks are considered less economically cyclical. They benefit as weaker economic growth is priced.
We favor Retail, Banks and Airlines now. They would benefit as/if 10yr yields grind lower and the economic expansion continues at the roughly 2% real GDP pace. These industry groups have lagged significantly.
Event risk is not behind us though. That is why we want to take advantage of implied volatility cheapening to hedge against yields spiking higher via options. Jeff Jacobson, 22V Derivatives specialist, likes hedging the TLT when implied volatility drops below realized volatility, as is the case now. From Jeff, “the last time the 2-month, 40 delta implied volatility traded at this much of a discount to the 2-month realized volatility was in mid-April. Shortly after, the TLT dropped -5% over the following month.”
Trade: Buy TLT July 17th 85/80 put spread for $0.85 (85.47 ref).
The logic of hedging volatile markets when implied vol drops applies to Software too. We have been long software since the beginning of earnings season (full details HERE). However, IGV has now increased +16% in three days. PANW, CRWD, and ORCL – which are 24% of the IGV – report in the next week and a half, a potential catalyst for volatility. We don’t like shorting Software, but hedges make sense here.
Jeff likes June 12th 104 puts for $1.94 (107.60 ref).
Charts…
Implied volatility is below realized volatility for the TLT. This year, that has been a good opportunity to buy puts. Longer term, yield vol will decline, but short-term, it is still a function of geopolitics.
The IGV has rallied +45% since mid-April and +16% in 3 days. We do not want to short Software, but hedging is appropriate.
The move in Software (ex Hyperscaler) valuations now discounts a lower but still significant, decline in earnings estimates or cash return. On their own, valuations imply the 5y forward EPS CAGR falling from 12% to 9% (or 2y forward EPS CAGR falling from 19% to 13%), or Cash Return falling from 88% to 77%. Together, something like an ~83% cash return ratio and an EPS CAGR of 10%. In 1Q, earnings estimates increased, and cash return remained stable. One quarter in, there is little evidence of the downside developing in aggregate. There will be relative losers, but some winners as well.
The below matrix shows Fair Value (% from current price) of different combinations of cash return and earnings, assuming that the equity risk premium was moving ahead of earnings and cash return estimates.
Correlations within Software dropped over earnings season. Stock picking is effective within Software again.
