Tuesday, April 15, 2014

The Big Unwind?

Matthew Boesler of Business Insider reports, The Big Unwind: Here's How Hedge Funds Drove The Brutal NASDAQ Selloff:
Volatility has returned to the markets, and growth stocks in information technology and health care have led the way down.

The chart above (click on image), from Deutsche Bank strategist Keith Parker, shows the extent to which fund positioning has helped fuel the recent decline in the stock market.

"Performance over the last month across stocks and sectors has been driven by position covering," says Parker in a report on recent investor positioning and flows.

"Through the first two months of the year, long/short equity hedge funds and mutual funds were neutral the market but long growth stocks, which helped underpin outperformance through the January-February sell-off. The rotation out of growth and into value starting in early March hurt and funds were forced to unwind positions."

Chart 2 provides a visual display (click on image below).

Coming into the first quarter of 2014, growth stocks and the stocks with the highest hedge fund ownership were one and the same.

Funds were loaded up on health care, consumer discretionary, and tech stocks (think biotech and social media), and the "momentum" trade did well in February following the big market sell-off in late January.

As chart 3 shows, the growth stocks were significantly outperforming the broader market until March (click on image below).

Since then, nearly all of the outperformance of this group of hot stocks has been erased as hedge funds have rebalanced, a process Parker says is probably almost over.

However, the unwind is "now spilling over to mutual funds that are still long growth, with outflows from growth funds exacerbating performance."

In the week through Wednesday, April 9, equity funds oriented toward growth stocks were hit with $1.7 billion of investor redemptions, following an outflow twice the size in the previous week. Flows into value funds, on the other hand, are accelerating — they took in $1.9 billion in the week through April 9 and $1.7 billion the week before. As one might expect from chart 1, consumer goods, utilities, and energy funds are receiving inflows while tech, health care, and financials funds are losing investor money.

David Kostin, chief U.S. equity strategist at Goldman Sachs, says the parallels between recent market action and that in March 2000, when the tech bubble burst, "dominated client discussions" last week.

"The current sell-off in high growth and high valuation stocks, with a concentration in technology subsectors, has some similarities to the popping of the tech bubble in 2000," says Kostin.

"Veteran investors will recall S&P 500 and tech-heavy Nasdaq peaked in March 2000. The indices eventually fell by 50% and 75%, respectively. It took the S&P 500 seven years to recover and establish a new high but Nasdaq still remains 25% below its all-time peak reached 14 years ago."

Kostin's take is that this time is different, as broad market valuations are not as stretched as they were then, and the "bubbly" parts of the market account for a much smaller portion of overall market capitalization today than then (tech accounted for 14% of overall S&P 500 earnings in 2000 but 33% of market cap, whereas today it accounts for 19% of both earnings and market cap).

While that is good news for the broader market, it's still bad news for these high-flying growth stocks (see chart 4, click on image below)).

"The stock market, but not momentum stocks, will likely recover during the next few months," says Kostin.

"Analysis of historical trading patterns around momentum drawdowns shows: (a) roughly 70% of the reversal is behind us following a 7% unwind during the last month; (b) an additional 3% downside exists to the momentum reversal during the next three months if the current episode follows the average historical experience; (c) if the pattern followed the path of a 25th percentile event a further 7% momentum downside would occur, or about double the reversal that has taken place so far; and (d) whenever the drawdown ends, momentum typically does NOT resume leadership."

On average, Kostin says, the S&P 500 has risen on average by 5% following momentum sell-offs like this, led by value stocks that underperformed as growth stocks were going up.

Jan Loeys, head of global asset allocation at JPMorgan, takes a similar view.

"Each of the market reversals of the past few weeks has in common that they represented widely held positions — long equities, overweight small caps, overweight tech, underweight emerging markets, and short duration," says Loeys.

"If there were greater worries about the economy or other downside risks, then we should have seen the dollar rise, credit and swap spreads widen, and emerging markets underperform. Correlations across risk assets should have risen. None of this has happened. There is no breadth to this sell-off."

Of course, there are, as always, reasons to be cautious. Many of them may relate to an optimistic scenario — one in which the economic recovery accelerates, causing the Federal Reserve to tighten monetary policy and interest rates to rise.

"S&P 500 price-to-earnings is demanding excluding mega-caps and likely dependent on interest rates staying low versus history," says David Bianco, chief U.S. equity strategist at Deutsche Bank.

Another factor to consider is corporate stock buybacks, which have restricted the supply of shares trading in the market.

"While everyone is focused on valuation and bubbles (to some degree rightfully so), the fact remains that the last few years have been supported by a low level of net equity issuance that has, all else equal, supported prices," says Dan Greenhaus, chief global strategist at BTIG.

This trend may now be poised to reverse as buyback activity slows, given the fact that shares have become more expensive as the market has headed higher.

"Rather than investing in new equipment and structures, businesses have used their cash positions to buy back stock or to grow through acquisitions," says Aneta Markowska, chief U.S. economist at Société Générale.

"This process, however, may be coming to an end. The ratio of the market value of equities to the replacement value of tangible assets (or the so-called Tobin's Q ratio) has increased significantly in the past year and now stands at the highest levels since 2000. With equity values currently estimated at 25% above replacement value, expanding organically seems to make a lot more economic sense than expanding through acquisitions or stock buybacks."

In other words, earnings per share have been boosted by a shrinking denominator — the amount of shares outstanding. If shares outstanding stop declining as buyback activity recedes and net equity issuance turns positive, it will put more onus on the numerator — the actual earnings — to propel earnings per share higher.

However, an acceleration in wage growth is a likely pre-requisite to Fed tightening. Such a development would pose a further headwind to earnings as corporations face rising employment costs.

"It now seems that what would be good for the recovery — higher labour income — will be detrimental for profit margins," says Gerard Minack, principal of Minack Advisors.

"This may be a good year for the economy, but profits may fall short of forecasts."
There is a lot of food for thought in the article above. First, the hedge fund curse is alive and well. When all the big hedge funds rush into hot stocks, looking for the big beta boost, these stocks tend to overshoot on the upside and downside. That is the nature of the momentum beast. If you can't stand volatility, forget high beta momentum stocks.

Nowhere is this more visible than the biotech sector which led the Nasdaq over the last few years and led the recent selloff. After peaking at 275 in late February, the iShares Nasdaq Biotechnology (IBB) which is made up of large biotech companies, now sits at 215, a 22% haircut in last few weeks. Worse still, the SPDR S&P Biotech ETF (XBI), which is made up mostly of smaller biotech names, got crushed, plunging from 172 in late February to 122, a near 30% haircut in the last six weeks.

Conversely, defensive sectors like utilities (XLU) have been on fire since the beginning of the year and they provide investors with a nice dividend yield so the total return is higher than just price appreciation. I can kick myself for not taking my profits in biotech and moving over to Exelon (EXC) at the end of January but hindsight is always 20/20.

Interestingly, as the article above alludes to, not all risk assets are being sold indiscriminately. Emerging market shares have staged somewhat of a decent comeback since the beginning of the year. The iShares MSCI Emerging Markets (EEM) is up 12% since late February and the iShares China Large-Cap (FXI) is up roughly 8% in last few weeks. Even more interesting, the iShares MSCI ACWI ex US Index (ACWX) has rallied nicely, up close to 8% since late February.

So what is going on? Nothing much except some profit taking and sector rotation. But there was also deleveraging and redemptions exacerbating the downswing as investors pulled out money from hedge funds at the fastest rate for more than four years in December, following a year in which many managers' performance disappointed.

Despite the massive selloff in growth and rally in defensive, emerging markets and ex-US shares lately, I maintain my views from my Outlook 2014 and hot stocks of 2013 an 2014. In fact, as I wrote last week when I warned my readers to beware of dark markets, this selloff in growth and biotech is overdone:
...let me just end this comment by stating that while tech stocks are getting whacked hard, the selloff in momentum stocks is overdone. The WSJ correctly notes that more investors are drawn into dividend stocks, but that's because they realize fears of Fed tapering are overblown and that more tapering will lead to deflation.

Why are momentum stocks selling off hard? A lot of it has to do with normal profit taking. Many of the hot stocks of 2013 ran up 300, 400 or 500 percent or more in the last couple of years so it's only normal they will get whacked hard from time to time. Regardless, I stick with my call in my Outlook 2014 and think all the bears getting greedy here will get their heads handed to them when these momentum stocks, including biotech stocks, snap back up violently. Admittedly, I am long biotech and this may be wishful thinking on my part as one of the smartest hedge fund talents in Canada recently told me he's very bearish on this market but I think he's timing is off (read my comment on the hedge fund curse).

Importantly, forget what all these overpaid strategists on Wall Street are recommending on television. When I see a Dennis Gartman on CNBC telling people he's scared and to "get out of stocks," (so his big hedge fund clients can buy them on the cheap), I know it's time load up on risk assets.

I am using the latest selloff to add to my positions in small biotech shares that got crushed recently, like Idera Pharmaceuticals (IDRA), my top small biotech pick. Interestingly, the drubbing in the biotech sector has been painful for Baker Bros. Advisors, the closely watched healthcare hedge fund with approximately $7 billion under management. Since March, the fund's portfolio holdings have been spanked hard (Baker Brother symbols to watch: ACAD, BCRX, IDRA, PCYC, PGNX, RTRX, XOMA).

There are plenty of other quality growth names in the Nasdaq 100 (QQQ) that are also set to soar higher after the latest selloff. For example, check out shares of Amazon (AMZN), Facebook (FB), Twitter (TWTR), Netflix (NFLX), and Tesla (TSLA), the most shorted Nasdaq stock.

The only thing going on is the Wall Street crooks are busy scaring retail investors using any means possible and creating all sorts of manufactured panic to buy shares on the cheap so they can ramp them up and dump them again at higher prices. This is what they'll do in the weeks and months ahead, get out of value/ dividend stocks and ramp up momentum stocks.

Bottom line is everyone needs to "CHILLAX" (a term I learned in Jamaica recently). There is no inflation, risks of deflation remain elevated, placing a cap on interest rates, and despite the gradual Fed tapering, there is plenty of liquidity to propel risk assets much, much higher.

To be sure, when the liquidity party ends, the titanic will sink. Momentum stocks will get crushed and stay down but value stocks will also be beaten badly. In a real bear market, there is literally nowhere to hide. Luckily, as Keynes famously quipped, "markets can irrational longer than you stay solvent," so all those bears betting on another 2008 right now are in for a nasty surprise as risk assets, especially growth and biotech, will surge much higher from these levels (and that's not wishful thinking).

Below, James Paulsen, Wells Capital Management, and David Blitzer, S&P Dow Jones Indices, share their outlook on the markets and bonds. Interesting discussion, well worth listening to.