'Trader's Market'? Careful What you Wish For.
Reader note: I’m going to start posting some notes that I write (usually weekly) on markets. Feedback has been strong, but admittedly to a fairly tight group. I’d love to hear your comments.
Originally from a note published May 29, 2020
Be careful what you wish for. Traders have for years hankered for a market offering more opportunities in single stocks, sectors, and factors. It’s here, just not necessarily in the version of itself that some envisioned.
It’s difficult to understate the amount of volatility that is gyrating under the market surface. Spasmic reversions in factor returns this past week had many scratching their heads. Some of this has been anecdotally explained as a ‘COVID basket rotation trade’ - the discounting of how long certain companies benefit from pandemic induced behaviour. As a return to normalcy is discounted, the thesis is that the high-flying beneficiaries of CV-19 return to earth. It’s easy to pin that narrative to days when stocks like Shopify, Zoom or Teladoc are down 20% in 3 days.
A handful of days with strong returns in cyclicals and value had some proclaiming that ‘the recovery is upon us, and industrials are back!’. How well did cyclicals do through recent periods of > 2.5% Real U.S. GDP Growth in early 2018 – end 2019? (answer: underperformed the S&P by about 10% over two years).
Given there is no historical data for anything resembling a basket of stocks that have idiosyncratic exposures to global pandemics, there isn’t any way to quantify this. I’m not saying some investors aren’t discounting an expedited recovery through buying cyclicals, I’m saying that the rotation has been short-lived, and we have insufficient data to expound ‘pandemic stocks’. Plus, most of the drivers of a ‘pandemic basket’ are captured by more traditional factors.
Periods with substantial economic distress and uncertainty have typically exhibited wild swings in factor returns. Here’s a chart I compiled of factor returns since 2007. Take a look at 2008-9 vs. today in terms of weekly factor returns. In short, the reverberations affecting relative factor returns took some time to settle down.
To date here are the quintile returns of the actual stocks with those factor exposures.
To conceptualize the extent of the factor rotations in stocks, focus on the 1w return versus the YTD. These are huge weekly moves, but in the context of the yearly underperformance in value, cyclicals, and leverage, it’s fairly minor.
On top of what may or may not be the beginning of a real rotation (it’s way too early to call), the impact of retail flows is substantial. We’ve all seen the Robinhood charts. It’s interesting that the rate of change on new positions is declining (will nice weather and re-openings crush the retail bid in the market?).
There’s also a strong case suggesting that equities with the largest intraday moves are highly correlated to changes in the number of Robinhood holders.
Short-term rotation events are going to present gut-check moments, just as they did through the GFC. Events related to insolvencies, weak labour markets, a potential second wave of CV-19, and the growing China conflict are risks to a pro-cyclical/value rotation. (Which is a bit of a misnomer in itself. Google, as an example of a stock that falls into the ‘not cyclical, not value’ category, generates about 85% of revenues from advertising revenue. The concept behind ‘secular grower’ ignores the fact that many of these stocks haven’t even seen a full cycle. And their customers are primarily other business also exposed to the cycle.)
Here’s a zoomed in look at the volatility of pure weekly factor returns since the beginning of the year:
Given that the leverage factor and the value factor are substantially inclusive, it makes sense that value is indicating high correlations across highly shorted and highly levered companies. In turn, these factors are highly correlated to increases user activity in Robin Hood account data!
Institutions are also carrying very crowded trades on their books. The below charts from Morgan Stanley indicate the record levels of concentrations among positions at hedge funds:
All of this tells me that we’re in for a continued period of volatility in factors, sectors and individual equities. This means don’t chase your favourite stocks and calculate your exposures to various factors driving a substantial part of this volatility.
Factor volatility that started in 2007 pre-GFC took over two years to settle down to ‘normal’ levels. Even in periods with the VIX at lower levels than today. Look again at the first chart I posted of factor returns: from mid-2009 to early 2010, the VIX compressed from 25 to 16. At the same time factor returns continued to be wild.
At only 3 months in, we can probably expect more volatility across sectors and factor returns. This can happen even if implied volatility grinds lower, as it did through the GFC.
In terms of overall market sentiment, Nordea makes a strong case that V-shaped economic survey shenanigans lead to FOMO markets. The IMF also commented that the coronavirus has "disrupted the production of many key statistics, which is in turn likely to cause problems with policy-making and assessing”.
My view is that the optimistic outlook being discounted in U.S. markets has a higher susceptibility to disappointment than at any point in recent weeks (months?). How this exactly plays out entirely unknown. The case for sector, stock, and factor volatility to remain at some heightened level (say over 20) for a meaningful period of time is strong. Maybe this is the traders’ market that many have pined for.
On the other hand remember the Jim Rogers mantra: “when there is nothing to do, do nothing”. For large full-cycle allocators and average investors, this may be the case. If you’re willing to stomach the cost of single stock and sector volatility, maybe this is some version of the market you’ve been wishing for.