From the desk of Tom Bruni @brunicharting
Telecom Threatening A Structural Breakdown
When I read about the Telecom sector or speak with colleagues about it, I find many people often think of it as a collection of companies with strong balance sheets, great cash flows, and shareholder friendly actions like juicy dividends and share buybacks. While that may be true in many cases, that doesn’t necessarily mean that the sector can be utilized as a bond proxy to boost a portfolio’s yield. As we saw in recent years with sectors exposed to high-yield, and MLPs, there’s no such thing as a free lunch. In addition to that, simple math shows that Telecom hasn’t been correlated with bonds (TLT) at all over the past ten years, with the correlation being 0.29, 0.19, and 0.08 over the past one year, three years, and ten years, respectively.
If you had adopted the above philosophy, stuck this sector in your portfolio and hoped for the best, you’ve seen that particular holding (IYZ) under-perform the broader market drastically in terms of price and total return since the 2007 peak.
If you’re choosing to actively manage your portfolio, it’s important to have a risk-management strategy for every portfolio holding, regardless of whether you own it for the yield or not.
The reason I bring this up now is because I think the Telecom sector is potentially setting up for a structural breakdown that could take years to repair before it can see higher prices. Yield is great, but not if years of payments are wiped out by a decline in price.
One more aside before I get into the price action. I realize that there are certain market participants out there, like pensions and endowments, that have a mandate to hold a specific allocation of dividend yielding stocks. These parties are often not looking for capital appreciation from these holdings, but instead are looking for volatility reduction in the portfolio and a consistent stream of cash flows. Falling prices in these sectors, like Telecom, may not affect them because they’re not necessarily worried about the temporary loss of capital over the short-term. For those of us who do not have these types of mandates or restrictions, or do not have as long of a time-frame, this development is much more relevant.
Price Action & Thesis:
The weekly chart of IYZ shows prices flirting with a big support level near 26.50-27.00. This level has been tested more and more frequently since prices broke the uptrend line from the 2010 lows and formed a multi-year rounding top. If prices break this level they’ll likely move lower to prior support and the 38.2% retracement of the 2008-2014 rally, which represents a 10% decline.
While this may not seem that drastic, the problem becomes the overhead supply that will be present at the 26.50 level after that. Prices have spent roughly 2.5 years above that level, so even if the decline is stopped near 24, it will take this market a lot of time to absorb that overhead supply before it can begin to move higher. That also assumes that the decline will stick to the initial 10% downside target and doesn’t test support and the 61.8% retracement of the 2008-2014 rally at 20, which represents a 26% decline from current levels. Again, nobody knows what this market will do, but we have to be aware that if a downtrend develops then these are likely the levels that prices will respond to.
The daily chart shows the roughly 3.5 point range between 27.50 and 31 that this sector has traded within since late 2013. Recently prices broke down below this range, suggesting that lower prices may be ahead. Despite the failed breakdown out of this range in the past, this breakdown may finally be sustainable because the 200 day moving average is now decisively sloping lower, which should support lower prices going forward. Momentum has also been in a bearish range for two straight years, and remains so today.
Another important factor is the correlation of IYZ to the S&P 500, which has been positive over the past month (0.94), quarter (0.95), and year (0.75). If you have a bearish view on stocks as a whole, which I do, the fact that they’ve been moving in tandem should add conviction to the bearish Telecom thesis. If prices remain below roughly 27.75 on a closing basis, the measured move for this pattern is roughly $24, which corresponds well with the first structural downside target discussed on the weekly chart.
As I discussed at the top of the post, Telecom has been a serial under-performer since the ’07 peak, and there is little evidence to suggest that trend is going to change anytime soon. Until this ratio can break back above the downtrend line from the 2011 highs with improving momentum, I don’t see any reason to think otherwise.
The Bottom Line: If you’re actively managing a portfolio, just because a particular asset class or sector of an asset class has a relatively good dividend yield, doesn’t mean you can ignore risk management altogether. As we’ve seen throughout history, chasing yield without regard to the risk involved can be result in exposing yourself to the massive risks of principle loss and opportunity cost.
With that being said, Telecoms are currently threatening to confirm a multi-year rounding top and break down from a structural perspective. If prices break 26.50 on a closing basis, the first structural price target is near 24.75, which corresponds with the measured move on the daily chart of 24. This represents 10% downside from current levels, while the secondary structural target of 20 represents a 26% decline from current levels. Price action relative to the S&P 500 continues to trend lower, and will continue to do so until the downtrend line from the 2011 highs is broken.
Overall, I don’t see any reason to be long this market on an absolute or relative basis at current levels, and would become more bearish with a close below 26.50 on an absolute basis. There is clearly more than one way to express that thesis of lower prices in the Telecom sector if it confirms, but that will depend on your individual investment / trading process, so therefore I won’t touch on that here. Instead I would simply urge you to keep an eye on this particular development, perform your own due diligence, and apply it where relevant to your own process.
As always, if you have any questions feel free to reach out and I’ll get back to you as soon as I can. @Brunicharting
JC here – I agree with every point that Bruni is making. I would add that looking at the list of components in the Telecom sector can help as well. Remember, IYZ tracks the Dow Jones U.S. Select Telecom Index. Top holdings like AT&T, Verizon, Century Link, SBA Communications, etc are all in strong multi-year downtrends. It’s almost inevitable that the sector as a group falls as well and completes this massive multi-year top. Also, I think Bruni’s last chart is very relevant to today’s interest rate conversation. As rates continue to fall (longer-end), money searching for yield heads towards higher dividend paying sectors. It’s telling that it hasn’t gone towards Telecom. The last chart of IYZ relative to S&Ps tells that story clearly. We’ll be watching to see if that changes later this quarter.
Tags: $IYZ $SPY $T $VZ $CTL $SBAC
The author does not have a position in the mentioned securities at the time of publication.
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