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RBC Is “Astounded” By The Magnitude Of This Rotation

Courtesy of ZeroHedge. View original post here.

This is “classic ‘shorts outperforming your longs’ stuff,” notes RBC’s head of cross-asset strategy Charlie McElligott, as he warns Friday’s VaR-shock is a worst-case scenario against a backdrop where post-financial-crisis highs in ‘net’ and ‘gross’ exposures are currently deployed by the majority of equity hedge funds. However, he does offer a silver-lining for stock dip-buyers (and what to watch for).

SUMMARY:

The acute ‘Growth : Value’ rotation accelerates in earnest around global equities, specifically with ‘Technology’ sector selling off sharply against rallying ‘Energy’ (perversely being squeezed-further by Crude’s +1.7% stop-run today)

Price-action evidences ‘VaR’ de-risking / grossing-down behavior, as consensual shorts painfully-outperform consensual longs

The extent of the relative ‘violence’ of the move shows extent of the positioning asymmetry—unlikely to be a ‘one day’ move per recent analog

Analyzing the eight prior instances of > 3 SD drawdowns in ‘Momentum’ market-neutral strategy drawdowns seen over the past five years, ‘Momentum’ (in this case long ‘secular growth’ against short ‘cyclicals’) bounces modestly on a T+1 week basis; however, it sees further and meaningful drawdown on T+1 month and T + 3month time horizons

Fascinatingly, this ‘Momentum’ rotation sees HIGHER absolute S&P price action on T+1 week- (+1.0% on avg), T+1 month- (+2.98% on avg) and T+3 month- (+4.6% on avg) intervals

To sustain the rotation into ‘Value’ and out of ‘Growth’ this week’s US inflation-data (and with it, Fed forward-guidance) is CRITICAL:

  • -Better data will either expose 2.31 / 2.32 level (Value = Energy, Fins, Materials and Industrials will continue to outperform); OR
  • -Weaker data opens back-up the 2.00% level (resumption of status-quo ‘barbell’ trade long ‘secular growth’ and ‘bond proxies’ for “slow-flation” outlook)

OVERNIGHT / HOW WE GOT HERE:

Once again, nearly the entirety of cross-asset market drama is being displayed ‘under the hood’ within the equities-space, against flattish rates and FX (USD soft to start the week despite the pending Fed-hike, as Yen strengthens through the ~110 level and helps to keep UST yields pinned ~2.20).  The other stand-out is Crude, breaking out to session highs through Friday’s best levels as stops are taken-out.

Risk-assets are again biased modestly-weaker to start ‘Fed hike’ week, as the global Technology sector-led equities sell-off is extended overnight into the US morning.  The same ‘Growth vs Value’ factor rotation dynamic which I’ve been hammering-home within US markets is being expressed internationally Monday, although without the benefit of higher nominal rates as a catalyst that we saw in the back-half of last week.  Japan experienced a session very similar to the US-one Friday, with ‘Tech’ -1.3% / ‘Telco’ -1.5%, along-side broad ‘Consumer’ weakness—while ‘Energy’ outperformed;’ Tech’ led the downside in several Asian / EM indices (SHCOMP ‘Tech’ -1.9%, ‘Telco’ -3.4%); while currently too we see ‘Tech’ as the worst-performing sector in Europe, with EuroStoxx Tech -3.6% and its worst day since June of ’16--‘Software & Services’ -3.5%, ‘Tech Hardware’ -2.8% and ‘Semiconductors / Semi Equipment’ -4.3 % on the day thus far.  And again in sharp ‘stick in the eye’ fashion, EU Energy is the day’s best sector, further squeezing higher, as Crude takes out stops per  above.

Consensual positioning is now being ‘bled’ on both ends, with particularly ‘VaR’ –shock behavior seen Friday afternoon.  Net / net, this sell-off in ‘market leaders’--which has gained-steam throughout the overnight and now morning--is now showing what looks to be ‘grossing-down’ / de-risking behavior.

The way I interpret this is that we are seeing essentially a pure ‘positioning-cleanse’ of ‘excessive’ longs and short exposures by risk-managers, obvious for all to see after ‘Momentum’ market-neutral strategies came unglued Friday (e.g. ‘long’ the top 10% of price-performers in a benchmark index over the prior 3m, 6m or 12m period against ‘short’ the bottom ‘10%, which had been extremely successful in Q2, especially for the 3m tenor), as a repositioning out of the high-flying ‘secular growth’ names (Tech, Consumer Discretionary) into the downtrodden ‘Value’ sectors (economically-‘cyclical’ ones like Energy, Financials and Materials, which were the S&P’s top 3 sectors on Friday) took-shape, as there is a hard-quantitative phenomenon of ‘alpha’ from H1 / H2 ‘Mean-Reversion’ strategies (selling leaders / buying laggards).

Just as painfully for the majority of consensual  buy-side positioning, today’s current global equities leadership comes again (just like Friday) via the ‘Energy’ sector, from Japan to EM to early Eurostoxx.  As I have painstakingly detailed, the ‘energy’ sector globally has been the chief ‘Cyclical Beta’ proxy since the start of the year through which many have expressed ‘underweights’ or ‘placeholder shorts,’ as a ‘slow growth / slow-flation’ view of the global economy developed and accelerated over the course of 2017 (recall, this is occurring after Energy actually led US equities sector performers in 2016, as crude exploded higher off of 14-year lows via 1) massive Chinese social financing / credit creation, 2) the infamous “Shanghai Accord” / Janet Yellen “dovish pivot” and 3) the original OPEC production cut agreement).  The price-action within the US Energy sector has been so perverse in fact that we have seen essentially a rolling ‘stop out’ party across the buy-side of market-neutral energy teams.

It should also then be noted too that I have seen a touch of this ‘stop-out’ dynamic within the Financials space as well over the course of an extremely volatile YTD.  JUST LIKE THE ENVIRONMENT INTO LAST YEAR’S JAN/ FEB / MAR FACTOR ROTATION, a very ‘growth-y’ and upbeat global economic outlook (and with it, enormous consensual views on higher rates / steeper curves) took shape following last year’s legitimate economic performance, rapidly ‘reflating’ energy and commodities prices and the ‘kicker’ of potential pending ‘fiscal policy’ upside post the Trump election.  And for the second December in a row too, we got a Fed hike, which further ‘enabled’ an enormous overweight to be built into the sector, attracting generalists into the space for the first time in years (remember my anecodotal convo about a large AM CIO who told me back in November of last year that they didn’t even have a banks team, following years of sector destruction at the hands of global central bank ZIRP / NIRP / QE policies which crushed nominal yields and curves?!).

Well, once-again, a similarly disappointing Q1 drove a significant re-positioning over the course of 2017, as funds fled the ‘cyclicals’ (with their massive interest rate- and Trump policy- sensitivities) and instead reached for the ‘barbell’ approach: long ‘secular growth’ (stuff that works regardless of the economic cycle / slowing-economy) and long ‘quality’ / ‘bond-proxies’ / ‘low vol,’ which act as a fixed-income yield surrogate and performed beautifully as everybody’s “higher rates” bets were routed, as UST 10Y yields ground lower from 2.63 highs made mid-March to the current 2.20 level.

All of this length was against the aforementioned underweight into the economically-levered stuff like ‘cyclical-beta’ / ‘small caps,’ ESPECIALLY as the initial ‘sugar high’ of the post- election euphoria wore-off, and US economic ‘soft’ /  survey data rolled over and with it, contributed to a mean-reversion in ‘hard’ data.

Unfortunately though for this group-think into the ‘hiding places,’ it enabled a positioning-asymmetry to develop, especially into consensus belief of the ‘slow-flation’ theme.  It was critical then to see US rates hold their lows last week (and the 61.8% retracement of the past year’s move), and as such, these extensively ‘short’ cyclical-positioning received a ‘upside convexity kicker,’ as rates then turned even just modestly higher which acted to ‘sling-shot’ what had been the year’s worst-performing sectors.

So now we have a backdrop where post-GFC crisis highs in ‘net’ and ‘gross’ exposures are currently deployed by the majority cross-section of equity hedge funds, into the worst-case scenario: massively crowded length is concentrated by-and-large in ‘growth’ and ‘momentum’ names / sectors for many funds, against shorts which are at multi-year high grosses in ‘cyclical’ sectors (‘Value’ factor)  that are consensually ‘underweight,’ and thus now leading the market higher, as risk-managers began to ‘gross down’ Thursday and Friday.  Classic ‘shorts outperforming your longs’ stuff.

WHAT HAPPENED FRIDAY:

  • US S&P ‘Value : Growth’ ratio saw its largest one-day gain since May of 2009, with Friday experiencing an insane 5.9 standard-deviation move (per all returns over that eight year period).
  • ‘Momentum’ factor market-neutral (3m) experiences a one-day -3.4% return, a 3.1 SD move and 4rd largest drawdown of the past two years (only behind 2/26/16, 10/2/15 and 8/10/15).
  •  My ‘Mean Reversion’ model experienced a 4.3 SD move, nearly tripling its prior QTD-best return.
  • My ‘Consensual HF L/S’ model saw a 2 SD drawdown in the context of the past two year’s returns, experiencing the 7th worst day since the enormous market-neutral factor-rotation unwind in Feb / Mar ’16.
  • All 15 names in the S&P 500 which traded >-4% or worse Friday were from the Tech sector à 6 of those names were from the “Semiconductor Devices” sub-industry group; 3 apiece from “Application Software” and “Semiconductor Manufacturing;” and 1 apiece from “Computer Hardware / Storage,” “Infrastructure Software” and “Internet Media.”

AS I’VE BEEN EXPECTING, EQUITY L/S PERFORMANCE WAS VERY EXPOSED TO A REVERSAL IN ‘VALUE : GROWTH’ AS EXPRESSED THROUGH ‘ENERGY : TECH’:

Q1 / Q2 Mean-Reversion Strategy exploded higher Friday:

HF L/S model experienced its 2nd worst return of quarter (after the severe -2.4% drawdown 5/17/17:

WHAT DOES IT MEAN GOING-FORWARD?:

I took a look at the five year window (dating back to 06/09/13) of instances where ‘momentum’ factor market neutral (3m) has seen ‘outlier’ 1 day drawdowns, defined by me as > 3 SD’s or more.  Curiously, all eight instances in my arbitrary five year window have occurred since February 2015 (none from June ’13 through January ’15).

From the perspective of ‘momentum’ mkt-neutral going forward after those drawdown events, the return performance is definitely interesting.  The table below shows us that the T+1 week return is roughly unchanged at +0.2%…but then on a T+1m basis we see ‘momentum’ mkt neutral -1.7% on average, and on a T+3m basis, the strategy is -2.7% on average.  In the case of the current market construct ‘ ‘regime,’ this would seemingly say that the general profile of leaders being ‘Growth’ / laggards being ‘Value’ would continue to see ‘Momentum’ performance ‘bleed’ modestly as per this admittedly small sample-size.

From a broad market perspective though, a drawdown / rotation of this magnitude in ‘momentum’ market-neutral actually sees an ASTOUNDING and OPPOSITE effect with broad indexThis recent evidence shows that following these outlier ‘Momentum’ drawdowns, S&P 500 on all window—T+1 week, T + 1 month and T + 3 months resulted in VERY strong positive returns for broad equities.

In this particular-case, that would absolutely require an enormous contribution from the Financials sector having to do the heavy-lifting with Tech and / or Consumer Discretionary becoming a ‘source of funds,’ as obviously, the rest of the ‘Value’ / ‘Cyclicals’ simply do not carry enough index-weighting to keep the SPX afloat.

As I have stated since day 1, in order for this ‘growth to value’ rotation to sustain into something more robust medium- to long- term, we need to see higher nominal rates, steeper curves and generally TIGHTER FINANCIAL CONDITIONS.  Friday’s move in context to the larger picture of this extraordinarily skewed US ‘value: growth’ ratio:

The fact of the matter is that the case I have been making from the pure ‘macro factor’ perspective for lower rates near-term (‘anchored’ by fading ‘inflation expectations’ since Q1 / Q2 transition) still remains somewhat in place—but without question is ‘evolving’ real-time, and with it, market expectations of ‘looser’ or ‘tighter’ global financial conditions:

1) Fed remains on ‘tightening’ message thus far, but let’s watch forward-guidance this week (ON TRACK ‘TIGHTER’ / HIGHER RATES FOR NOW, BUT POTENTIALLY EVOLVING IF INFLATION SOFTENS FURTHER);

2) US PPI and CPI data this week will be of CRITICAL importance for the ability of rates to continue higher or not (UNDETERMINED and BINARY);

3) Last week’s ECB ‘dovish’ messaging countered the recent ‘less dovish’ nuancing (CHANGE ‘LOOSER’WHICH KEEPS RATES LOWER);

4) Chinese deleveraging efforts seeing recent pause, as short-term rates have reversed lower and liquidity has been injected by the PBoC (CHANGE ‘LOOSER’ WHICH KEEPS RATES LOWER)

5) Seasonality of US economic data surprise ‘beats’ transitions to ‘in favor’ starting in July—see below (BETTER DATA, HIGHER / ‘TIGHTER’ NOMINAL YIELDS)

For those of you keeping score at home on the above list, that makes a ‘push’—with inflation data (and Fed guidance) the ‘tie-breaker’ for ‘Value : Growth’ debate going-forward.

As such, for all of the questions on ‘what inning’ are we in of this unwind--or more appropriately, “are the conditions ‘the right ones’ to sustain the rotation into ‘Value’ from ‘Growth’ (as well as into ‘Size’ from ‘Quality’ and ‘Beta’ from ‘Anti-Beta’),” my view is that we need to see SOLID INFLATION DATA and ‘on message’ with forward guidance (“transitory”) to see this move escalate meaningfully from here.

Any wobble with inflation data this week still sees potential for the ‘rates shorts’ to be squeezed lower again (remember, they showed up again Thursday and Friday of last week), and with it, Fed language is likely to pivot modestly more ‘dovish’ again.  This is the negative scenario for ‘Value : Growth’ rotation.

Strong inflation data and ‘on message’ “tighter” Fed on the other-hand, the 2.31 / 2.32 would be exposed, and ‘Value’ can absolutely run further at the cost of ‘Growth’ equities (and ‘Anti-Beta’) as obvious ‘source of funds.’

*  *  *

So to simplify, McElligott is saying that if history is a guide to this kind of “astounding” shift in momentum, traders should BTFD in the S&P… except, as he notes, the key going forward is direction of rates

This week’s inflation data is mission critical, as it will dictate whether Fed stays on message or not.

If it comes inline to better, Fed stays on message regarding tightening path, value will continue to scream higher (and financials have the ability to do the heavy-lifting for tech).

If it comes weaker and Fed is interpreted as dovish, the mean-reversion will mean-revert again, and secular growth and defensives with again run higher at the expense of cyclicals / value.

Therefore, as always, it’s all about The Fed. If, as Goldman has suggested, The Fed surprises with a non-dovish hike this week, then all bets are off.


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