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Reflation Trade?

The Federal Reserve announced today Wednesday, 9/16/20 that they will keep U.S. interest rates near zero until the U.S. economy fully recovers from the effects of the Covid-19 pandemic and until the labor market returns to normal. This suggests the FED will allow U.S. inflation to rise above its 2% target for an unspecified duration. FED chair Powell also mentioned the importance of more fiscal stimulus that is needed to help the U.S. economy recover back to pre-COVID-19 levels.


Does this then imply a better U.S. economy in the future? And, most importantly will this lead to the next reflation trade?

Reflation is a term that is often used to describe a fiscal or monetary policy that will help to expand economic output, stimulate consumer spending, and reverse the effects of deflationary pressures. Tax cuts, infrastructure spending, expanding the money supply, and lowering interest rates are often associated with policies that spur on reflation.


Reflation occurs soon after an economic contraction and periods of economic uncertainties such as a business recession. The term typically describes the first phase of an economic recovery. A reflation is a form of inflation. However, it is considered a form of "good inflation" as compared to "bad inflation" as this signals the economy is beginning to recover or inflate back to its normal trend line.


A cyclical uptick in the economy may present trading and investment opportunities for some of the economically sensitive sectors such as Consumer Discretionary, Materials, and Industrials. So, with the recent consolidations taking place in the Technology, Telecom, and momentum-based areas as well as sentiments beginning to shift toward other areas of the stock market will this lead to the next reflation trade?


There appear to be sector rotations toward Consumer Discretionary, Materials, and Industrials, at least from a near-to-medium term perspective.


A brief review of the Relative Rotation Graph (RRG) over the past 8 weeks ending on September 14, 2020, shows the Consumer Discretionary sector (XLY +9.7% change), Materials (XLB +8.4%), and Industrials (XLI +11.0%) all residing within the Leading Quadrant. Further note their relative outperformance against the S&P 500 Index (SPY +6.0%) during this same period.


Although Technology (XLK +9.5%) and Communication Services (XLC +6.5%) retain longer-term secular leadership roles both sectors have slipped deeper into the Weakening Quadrant. This supports the basis that these leadership sectors may be undergoing consolidations, a process that can help to alleviate their overbought conditions before the resumption of their primary uptrends.


Based on another technical ranking study (SCTR) it suggests there is an increase in trading and possibly investment interests in the three reflation sectors – Consumer Discretionary, Materials, and Industrials.

SCTR is a numerical scoring and technical ranking system based on 6 key technical indicators across 3-time frames (i.e., short-term, intermediate-term, and long-term). A quick snapshot of the top 100 ranked SCTR stocks from the large-cap universe (i.e., SPX Index) shows 29 Consumer Discretionary stocks, 21 Industrial names, and 13 Materials securities. This would imply 69% of the top-100 ranked large-cap stocks now comes from these three sectors.


Although Technology (14 stocks) and Healthcare (10 stocks) remain secular growth sectors they have both slipped over the past month or so. This suggests a corrective phase within a long-term bull trend.

Entering the fall seasonality weakness period and the end of the third quarter it may be an ideal time for traders and investors to further rebalance their portfolios. This is especially important if a client's portfolio is overly concentrated in some of the momentum and high growth areas of the marketplace.


Enclosed below is the RRG chart study as well as the top 100 SCTR large-cap stocks and rankings of stocks by S&P 500 sectors.


Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

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