A Trade for Peace

By TradeSmith Research Team

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Which market sector would you most expect to have made a new high between February 2022 and October 2023?

You’d have two big reasons to pick the defense sector…

February 2022 saw the Russian invasion of Ukraine, a conflict with hundreds of billions of U.S. spending behind it and no clear end. And just one month ago, war erupted between Israel and terrorist group Hamas.

Wars are, unfortunately, good narrative drivers for defense stocks. The more conflict in the world, the more defense companies can fill their coffers.

And the narrative is sound. The iShares U.S. Aerospace and Defense ETF (ITA) rose over 14% in the month after Russia invaded Ukraine. And since the Hamas attacks on Oct. 7, ITA is up 12%.

But you’d be wrong to think defense stocks are making new highs. In fact, they’re lower than they were before the pandemic… and facing stiff resistance.

Per the TradeSmith Analytics dashboard, ITA is the single most overbought sector in the market, despite being a relatively weak performer over the past several years.

This looks to me like a case of the Wall Street narrative machine getting out of hand again. So let’s dive into ITA and see what the most likely next move is for this overly hot sector…

And at the end of today’s essay, I’ll show how you can use TradeSmith’s in-house A.I. system to figure out the best way to trade ITA right now…

Why Defense Stocks Are Set to Fall

Let’s zoom in to the last year of ITA price action…

First, let’s unpack the colored horizontal price levels I’ve marked on the chart.

Near the top of the chart, the red horizontal line marks the pre-pandemic high for ITA, which it has yet to close above. We can see that it’s acted as a powerful resistance level even in 2023, with ITA rejecting off of it no less than four times since the start of the year.

Below that, the yellow level is what I’d call local support for ITA. It’s a level where traders have scooped up shares in June, July, and earlier this month. The two green lines below that are even stronger support, as traders have bought at those levels aggressively throughout the past several years. This level is our rough price target for ITA, should it roll over.

And ITA looks ready to roll over. It’s failing to follow through on a new high despite being wickedly overbought on the Relative Strength Index (RSI) indicator (the purple line on the bottom half of the chart). In fact, the RSI is at its highest level since the massive COVID bounce that hit nearly all sectors in June 2020.

The fact that ITA didn’t participate in Tuesday’s face-ripping stock market rally is also telling. Investors are shunning the sector in favor of more politically neutral bets, despite ongoing war on two major fronts.

And news out this morning, of Congress passing a stopgap funding bill to prevent a government shutdown until January, notably leaves out additional aid for Ukraine and Israel.

It’s important to note that government aid for these two conflicts doesn’t necessarily or immediately turn into profits for companies in the defense sector. But media narratives — like the U.S. government backing yet another conflict with untold billions of dollars (or not) — are what drive capital into the market, one way or another.

All of this tells me we should expect some amount of selling in ITA over the next several days to work off these overbought conditions. I would first look for ITA to trade at its local support level, around $111.50. Think of it as a “trade for peace” — betting on defense stocks to lose their luster.

But I want to bring in one more piece of evidence that you should always check before you place a trade…

What AI Recommends for ITA

Earlier this year, TradeSmith introduced An-E. You can think of it as ChatGPT for the stock market, only instead of writing you poetry using data from 2021, An-E helps you forecast market moves and pinpoint the best strategies to trade them.

Recently, An-E has gotten an update with a brand-new options trading algorithm that’s included for Predictive Alpha Options subscribers.

This tool scores tickers from 0-100 for any stock or ETF in the market.

The higher the score, the more bearish the strategy our tool recommends.

I plugged ITA into this new tool yesterday morning. As I write, ITA scores an 84 on our options rating…

That puts it in Zone 6, all the way at the right of the scale. At this level, the tool recommends we buy speculative puts on ITA, buy protective puts to hedge against price declines if we own the stock, or write covered calls against our holdings at high strike prices, with the assumption they won’t be exercised.

We can also see that ITA has climbed higher and higher into that zone over the past month and change.

I highlight this tool for two reasons.

  • To show the slew of strategies you can use to profit on bearish trends in individual stocks and sectors.
  • To demonstrate the incredible power of trading with TradeSmith’s predictive toolset.
As I mentioned recently, I believe learning to trade will be the most important skill of the 2020s. That’s not to say it’ll be easy. There’s a steep wall to climb before anyone can call themselves a knowledgeable trader, no less a competent one.

Using TradeSmith’s tools, however, makes that process much simpler.

It’s like the difference between free-climbing that wall with a load of rocks in a backpack… and being strapped to rock-climbing superstar Alex Honnold.

As a TradeSmith Platinum subscriber, you should know that you already have full access to the Predictive Alpha Options tool. Just go to TradeSmith Finance and scroll down to get started.

To your health and wealth,

Michael Salvatore
Michael Salvatore
Editor, TradeSmith Daily