This was quite a week for US markets, although you wouldn’t necessarily know it if all you were looking at was the relatively pedestrian ~1% gain the S&P had logged through 3:00 PM Friday.
There’s a lot to digest in the following chart, and that’s on purpose. I want to try and capture as much as possible for readers here in a few visuals in the interest of brevity and clarity.
The top pane is straightforward. The S&P is riding a three-week win streak having recovered from the four-week slide that accompanied the August trade drama.
The bar chart in the bottom pane shows the weekly change, in basis points, in 10-year US yields on the right axis. The area chart on the left axis is the 10-year yield itself. The vertical yellow line, as indicated, marks the election. When 10-year yields are above where they stood when the election was held (i.e., above the “Trump line”), the chart is shaded purple. When they’re below that level, the chart is shaded blue.
A couple of things stick out. This week saw the biggest weekly gain for 10-year US yields since 2016. The ~35bps rise means we’re back to “even” (if you will) since the election. The scope of the selloff in bonds is quite something. We’ve now nearly erased the rally seen in August which, as a reminder, was the best month for US government debt since December 2008.
As you’ve probably heard by now, this rapid rise in yields played havoc with consensus positioning in bond proxies, secular Growth and Momentum earlier this week. Indeed, Monday’s factor reversals were dubbed “one of the more stunning trades in modern market history,” by Nomura’s Charlie McElligott who, in a note to clients that morning, suggested that any continuation of the duration selloff and/or bear steepening impulse risked catalyzing dramatic rotations.
And dramatic they most assuredly were. In fact, Monday saw an 8.5-standard deviation move in McElligott’s “Pain Trade” index (basically the ratio of a Value factor proxy versus Momentum):
The 7.7% Monday move in Nomura’s one-year price Momentum factor was the second-largest single-session drawdown in history going back to 1984, eclipsed only by a -8.2% bloodbath on April 4th, 2009. Here’s what McElligott had to say about it on Tuesday:
And yet HILARIOUSLY, nobody watching financial TV or Joe Schmoe retail investor looking at just simple Index returns in isolation (or even a more sophisticated investor looking at the Vol complex yday) would have had ANY idea of the calamity occurring under the surface, as it was all about a blowout in sector- and thematic- dispersion which then acted to offset / “mask” the “top down” moves.
This was not good news for the Long/Short crowd, something you can read more about from Bloomberg here.
But you’re not a L/S hedge fund, so why should you care?
Well, for a number of reasons.
Narrowly speaking, this astonishing rotation played out across popular Growth, Value and Momentum vehicles, many of which are widely owned. For instance, the iShares S&P 500 Growth ETF (IVW) underperformed the iShares S&P 500 Value ETF (IVE) by the largest margin since 2009 this week.
In the same vein, the iShares Edge MSCI USA Momentum Factor ETF (BATS:MTUM) underperformed IVE by a black-swan-ish margin. The chart below isn’t a perfect way to visualize the rotation, but it is the most reader-friendly for general audiences as these are widely recognizable vehicles.
Note that I plot the relative performance with 10-year yields. Momentum has become highly correlated with rates.
As Goldman wrote this week, “our recent Factor Barometer shows Momentum and Volatility are both significantly inversely correlated to rates currently at ~-50-55%; < 5th %ile vs history, suggesting the recent backup in rates has been a likely catalyst [for the rotation]."
This raises questions about whether the long-awaited Growth-to-Value rotation has finally arrived and, along the same lines, if we can now expect outperformance from Cyclicals and other laggards.
That, in turn, means investors need to consider whether their portfolios are tilted too heavily towards “winners” and bond proxies. Earlier this summer, JPMorgan’s Marko Kolanovic warned about a historic bubble, which he illustrated with the following visual:
Generally speaking, this is all the same narrative, something Kolanovic summarized neatly in a note out Tuesday. To wit:
Many similar indicators suggest the gap is not sustainable between Value, Cyclicals, SMid and high beta stocks on one side, and Momentum, Low Volatility, and Growth on the other side. [Monday saw] a ~5 standard deviation rally of Value versus Momentum.
Opinions vary on whether the rotations seen this week are sustainable or merely reflect a positioning cleanse catalyzed by a similar washout/correction in the rates space, where the bond rally had clearly run too far, too fast.
There’s more than a little nuance to be had. The outlook for Momentum after these types of earthquakes isn’t good. Here’s an annotated visual from Nomura’s McElligott that tells the story via the same one-year price Momentum factor mentioned above:
Goldman was out on Wednesday driving the point home. Here’s a bit of brief color from a very long note on all of this:
Sharp Momentum drawdowns similar to the one that has taken place in the last two weeks usually mark the end of the Momentum rallies rather than tactical buying opportunities. One reason Momentum rarely rebounds following sharp drawdowns is that the composition of Momentum frequently changes. From a macro perspective, Momentum typically performs best during extended periods of macroeconomic and market consistency. Looking forward, for Momentum to resume its outperformance, investors will need to either return quickly to the mindset of economic deceleration and recession risk, or wait until Momentum builds again in a form appropriate for an improved economic environment.
That gets at the heart of the issue. The backup in yields this month is attributable to a string of decent economic data out of the US (the ugly ISM manufacturing print notwithstanding) and a laundry list of reasonably positive geopolitical developments including Boris Johnson seeing his no-deal Brexit plans stymied, Carrie Lam formally withdrawing the extradition bill at the heart of the Hong Kong protests, Italy averting what amounted to a hostile takeover by Matteo Salvini and, of course, progress on a Sino-US trade deal.
If the macro picture continues to brighten (even marginally) and yields continue to rise without jumping so fast as to create “tantrum” conditions, investors could well see the rotation continue, even in the absence of any definitive resolution to political powder kegs. SocGen’s Andrew Lapthorne underscored this on Thursday. Here’s a quick passage from his take:
There is too much bond price momentum priced into asset prices and to hedge this risk you need to buy cyclical upside. Too many investors are poorly exposed to positive news. Value stocks, a portfolio of doom-laden stories as we have seen in recent days, provide such a hedge.
Of course, the macro backdrop really hasn’t changed all that much. Taking the points above in turn, Boris Johnson is still determined to pull the UK out of the EU even without a deal, and just because it won’t happen on October 31, doesn’t mean it won’t happen on January 31. Carrie Lam’s formal withdrawal of the extradition bill was seen as far too little, far too late for protesters and violence in the city continues to escalate on weekends. Italy appears stable for now, but Salvini’s League is still the most popular party and although his attempt to seize the premiership failed, Matteo will bounce back. And it goes without saying that the US-China soap opera will continue indefinitely.
Any renewed deterioration in the geopolitical backdrop or further signs that the global economy is headed for a downturn could easily tip the scales back in favor of the bond bulls and the deflation camp, thereby pushing equity investors right back into the same sectors and trades that have served them so well, for so long.
Whatever the case, this week showed just how dramatic things can get under the hood when crowded positioning tips over, and it also underscored the extent to which no equity investor can afford to ignore what happens in rates.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.