The fresh tailwind behind homebuilders … assessing the strength of the trade today … what if our timing is wrong? … a powerful risk mitigation tool
Today, let’s review a trade we suggested two years ago that’s been very profitable.
But more important to you if you’re not in this trade, we’ll discuss how to ride it for more gains starting today. We’ll also incorporate a powerful risk mitigation tool to protect our returns if the market starts to head south.
Let’s jump in.
The bull market in homebuilding stocks keeps roaring
In our April 20, 2022, Digest, we suggested that aggressive investors could initiate a trade on the iShares Home Construction ETF, ITB. It holds homebuilding heavyweights including DR Horton, Lennar, NVR, Pulte, and Toll Brothers.
If you had acted on that Digest, you’d be up 115% right now, roughly 4Xing the S&P’s 29% return over the same period.
Despite this triple-digit pop, ITB looks primed for more gains today for one primary reason…
The new rate-cutting cycle.
As you’re aware, the Fed cut its target rate by 50 basis points one week ago. It also indicated that it anticipates another two quarter-point cuts by the end of the year, followed by four more quarter-point cuts next year.
These lower rates will goose a handful of sectors, and housing/homebuilding is among the biggest beneficiaries. There are two major reasons why:
- Lower mortgage rates will bring down the all-in cost of being a homeowner, leading to more demand for homes
- Lower interest rates reduce borrowing costs for homebuilders, which boosts margins and improves profitability
It’s a double-whammy win.
It gets better…
From a valuation perspective, ITB has loads of runway in front of it to support a continuation of its bull run. While the overall S&P 500 trades at an expensive price-to-earnings (PE) ratio today of 29.9, ITB trades at a PE of less than half that – just 13.9.
While this might mean ITB has bullish tailwinds on a macro basis, is now – right now – a good time to enter this trade?
To help with our analysis, we’re going to borrow from our hypergrowth expert Luke Lango and his trading service Breakout Trader.
Specifically, we’re going to look at two of Luke’s preferred indicators: the Relative Strength Index (RSI) and the Moving Average Convergence/Divergence (MACD) indicator.
The RSI is a momentum indicator that measures the extent to which an asset is overbought or oversold. A reading over 70 suggests an asset is “overbought” (and likely poised to pull back as traders take profits) while a reading below 30 means it’s “oversold” (and poised for gains as bargain-hunters step in and buy).
Meanwhile, the MACD indicator reflects changes in a price trend’s strength, direction, momentum and duration. Traders use this tool by analyzing the location of the MACD line relative to its signal line.
At its most basic interpretation, if the MACD crosses above the signal line, it’s considered a bullish crossover, and potentially a buy signal. The opposite is true as well.
Below, let’s look at ITB along with its RSI and MACD.
For the RSI, note that it comes in at 61. This suggests healthy, bullish price momentum in a move that isn’t yet overbought. However, notice that the RSI line is trending lower after having been above 70 last week. This reflects recent weakness.
For the MACD (the black line), it’s been rising above its signal line (the red line) at a relatively high level, though it isn’t at a nosebleed reading. Here again, this suggests a broader, bullish move but not a move that feels overextended.
However, note that the MACD has begun moving sideways to slightly lower since mid-month. This suggests that the most recent price movement is weakening.
So, what’s the takeaway?
Well, overall, there’s plenty of strength here, yet the latest price action suggests the bullish move is growing tired. That means we could mean we find ourselves underwater in the coming days/weeks if we start a trade today.
Clearly, that doesn’t sound all that great. So, do we wait?
We could. Of course, there’s always the chance that bulls come out roaring tomorrow and ITB pops 3%+ and is off to the races, making our caution appear to be a bad move.
How do we resolve this?
That brings us back to last night…
Yesterday evening, our macro expert Eric Fry sat down with Keith Kaplan, the CEO of our corporate partner, TradeSmith
Part of their discussion highlighted a series of quant-based trading tools from TradeSmith that are engineered to help investors optimize their trade management.
One of the tools that I find invaluable is TradeSmith’s trailing stop tool. This is because it factors in the specific volatility of any given stock/ETF to help investors answer a crucial question…
When you’re in a pullback, how do you know whether it’s just normal volatility to ride through, versus a “this time is different” drawdown to avoid immediately?
If you don’t know this answer, you might get shaken out of a great trade prematurely and watch as gains snowball with you watching from the sidelines…
On the other hand, without knowing this answer, you might stay in a bad trade expecting it to bounce back, only to watch your losses accelerate until it’s a portfolio-busting loser.
At the heart of this are two important truths of trading…
Volatility is not the same thing as risk, and volatility isn’t uniform across all stocks
Luke made this point in a past issue of Breakout Trader.
Big picture, risk management is the name of the game when it comes to trading safely for the long haul. To that end, stop-losses and wise position sizing are critically important.
But many newer traders don’t give their stop-loss amounts enough thought. Instead, they apply the same stop-loss percentage to all their trades.
That doesn’t make sense.
Below, we compare two stocks: perennial blue-chip Coca-Cola (KO) and Matador Resources (MTDR), an oil and gas exploration company.
From October of 2021 through mid-May of 2022, both stocks climbed exactly 27%. But the paths they took to get there were wildly different.
See for yourself. Matador is in green. Coke is in black.
Coke’s path is far smoother than Matador’s comparatively “violent” series of ups and downs.
Given this, would using the same stop-loss percentage have been appropriate for both stocks?
Clearly not. That would have ignored the reality that Matador’s normal volatility is far greater than that of Coke’s.
But that doesn’t mean Matador is a “riskier” stock. It just means traders need to factor this greater volatility into their position sizing, trade expectations, and stop-loss levels.
TradeSmith’s trailing stop tool factors in these unique volatility thumbprints, generating a proprietary “Volatility Quotient” (VQ) reading that helps investors know how much volatility is normal and to be expected.
Here’s the official description:
The Volatility Quotient (VQ/Risk) indicates how volatile an investment is based on at least one year’s historic price action. This ensures the user takes the right amount of risk in any trade based on TradeSmith algorithms.
We utilize the VQ to determine the trailing stop for our Health Indicator and VQ trailing stops for positions tracked within TradeSmith. The lower the number, the more stable the movement of that stock. Higher percentages indicate the stock is more volatile in its market moves over time.
This enables investors to identify tailormade stop-losses for each specific stock they own, based on their unique entry timing.
So how much downside should an investor give ITB if they hop into a trade today?
As I write, TradeSmith’s VQ algorithm suggests that normal volatility for ITB could see it move up to 23.47%. So, we could set our trailing stop loss percentage for 23.47% since a decline greater than this would suggest a move beyond normal volatility.
Now, let’s take this one step farther. Let’s use this VQ reading to help us define our risk and set an appropriate position size.
For example, say we want to cap our potential downside at $1,000 if things don’t go as expected. In other words, this is the max we want to risk losing. Well, based on our VQ reading (and chosen trailing stop loss percentage) of 23.47%, that means we can invest a total of $4,261.
Mathematically, here’s how that works…
If $4,261 is our initial investment, and ITB falls to our stop loss of 23.47%, that leaves us with $3,261, which represents our “max loss” of $1,000.
So, with this tool, we can calculate how much to put into our ITB trade, identifying exactly where we’ll get out if it turns against us, and what that would mean for our portfolio value.
I’ll add that TradeSmith also has an entry timing tool, providing guidance on when bearish momentum has shifted, and investors are likely standing at the beginning of a new bull run.
If you’d to learn more about TradeSmith and these tools, click here to watch a replay of last night’s event with Eric and Keith.
As for ITB, we remain bullish and believe the next six-to-12 months will reward investors who initiate a trade today
That doesn’t mean it won’t be volatile, and based on the technical charts, it doesn’t mean we might not sit on some temporary losses if we buy today.
Despite this short-term uncertainty, all signs we’re seeing point toward far greater gains on the way in the longer-term.
And if we’re wrong? Well, by using an advanced stop-loss tool reflecting ITB’s specific, historical volatility, we’ll know when to call it a day.
Fortunately, we don’t see that happening anytime soon.
We’ll keep you updated.
Have a good evening,
Jeff Remsburg
