I am writing this article for a couple of reasons. The first reason is the fact that I have been bearish on the economy since the second half of 2018 when the economy peaked. This has resulted in growth slowing and me advising my readers to avoid cyclical stocks as much as possible. In this article, I want to show you why industrial stocks might be the most important sector right now and why it makes sense to keep industrial stocks on your radar. XLI is one of the best tools for retail investors to gain alpha and a higher dividend yield without having to take too much risk. So, this article will cover the current situation and the reasons to be long XLI once the timing is right.
Note that I mean the SPDR Select Sector Industrial ETF when I am talking about “industrials”. This is the most active industrial ETF and the best tracker of the S&P Industrial Index.
Source: KPMG International
The Big Picture
Readers who frequently read my article knows what I am going to say in this part. The sad reality is that the global and US economy is in a strong downtrend since the end of 2018 when US growth peaked. The global economy peaked in Q1 of 2018. The graph below shows the ISM manufacturing index. This leading index for the US economy has been one of the best predictors of ‘hard’ economic growth and is still very valid as I will show you in this article. In September, the ISM index fell to 47.8, which is 2.1 points below the neutral 50.0 level, indicating economic contraction.
If you want an in-depth view of the economy, feel free to read this article which covers the most recent data.
The reasons why I keep analyzing the economy based on leading indicators and why I so often keep referring to the ISM index is the fact that the index drives mid-term cycles. The growth cycles you see in the graph above can also be found in the graph below. Below, you see the long-term chart of the industrials ETF (XLI).
Declining economic growth does not necessarily mean a mega stock price crash. However, it means that industrials and the stock market in general are hitting a ceiling. For example, since the start of the global growth peak in Q1 of 2018, industrials have failed over and over again to break out. Capital gains since the start of 2018 are zero.
We are now even entering a period where leading growth is increasingly impacting ‘hard’ economic data like industrial production and manufacturing jobs. Total industrial production hit a cycle low at 0.4% in August, which is more than likely going to end up being a negative number in the months ahead, given the trend from the ISM index and regional manufacturing surveys. Manufacturing jobs growth has also hit a new cycle low at 0.9% in September. It really starts to look like we could see a loss of manufacturing jobs unlike 2016 when the US economy narrowly escaped such a scenario.
With regard to the first graph of the article, I could have used the S&P 500 graph as a replacement. Both are moving fairly in lockstep and are therefore often showing the same patterns. The reason why I am writing this article becomes clear when looking at the ratio between industrial stocks and the S&P 500. The graph below shows the ratio between industrial stocks and the S&P 500 (black line) as well as the ISM index (orange line). To summarize the graph below in one sentence: buy XLI once the economy shows signs of a bottom and sell once the economy starts to peak.
As the name of this website is Seeking Alpha, and as most investors want to be long the right stocks during the right time, I think it is appropriate to monitor the economy and the XLI ETF.
XLI Is A Great Trading Tool
There are a lot of different traders. One group that should use the XLI ETF is the group that aims to earn a steady long-term income from both capital gains and dividends. I often say that stocks like Caterpillar (CAT) are the perfect tools to track the economy. However, that’s what I would recommend to traders who are more active. Buying XLI is a great way to be long an alpha generating ETF without having to deal with a much higher volatility.
Moreover, and this is also interesting, given that most bull cycles tend to have a duration of multiple years, the XLI ETF is offering a higher dividend yield than the S&P 500. At this point, the dividend yield is 2.11%, which is 23 basis points above the S&P 500 yield. The current divergence is obviously caused by the fact that industrials are underperforming. However, once growth slowing gets more severe and pushes XLI down more, the yield tends to rise to 2.3%. That’s obviously not the kind of return you get when buying high-dividend aristocrats. Nonetheless, you should be able to outperform the inflation rate while generating alpha during bull markets.
One should also consider that XLI has an expense ratio of 0.13%, which is just marginally higher than the S&P 500 ETF (NYSEARCA:SPY) expense ratio of 0.09%. In other words, a higher yield and potential outperformance are not ending up as higher fees.
Adding to that, I want to quickly show you the biggest holdings of the XLI ETF. The ETF holds 70 stocks. The top 10 has 44.7% of the ETF’s exposure. As you can see, most of the biggest holdings are stocks you think of when discussing industrials. The ETF holds machinery stocks, aerospace & defense, railroad transportation, and conglomerates (and many others).
The Bottom Line
The XLI ETF is one of the best trading tools on the market, in my opinion. Even though it is a very boring ETF that just tracks 70 of the most important industrial stocks. The ETF delivers serious alpha during economic upswings and has an interesting dividend yield while you are waiting for capital gains. The ETF is just 4 basis points more expensive than the S&P 500 ETF and has already shown some serious underperformance this year.
I am closely monitoring this ETF as I want to buy some of its holdings once the economy turns. If you (just like me) have cash sitting on the sidelines, I advise you to wait before the economy (ISM index) starts to bottom. Once that happens, you should deploy some of your cash in XLI. Especially if you want to avoid volatility from single-stocks and like to hold investments for more than 12 months.
Once the economy bottoms and XLI is positioning itself to break through the massive ceiling (resistance), I think we will see a ton of alpha and capital gains in general.
Thank you very much for reading my article. Feel free to click on the “Like” button, and don’t forget to share your opinion in the comment section down below!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.