Quant Quake 2.0 and QE Infinity Unnerving Investors?
The stock market may appear tranquil again after a rollercoaster summer, but many analysts and investors are unnerved by violent moves beneath the surface, reviving memories of the 2007 “quant quake” that shook the computer-driven investment industry.Ian Young of ETF Trends also reports on how value stocks can be a huge play, according to one J.P. Morgan expert:
The FTSE All-World equity index has rallied almost 3 per cent already this month, clawing back some of August’s losses. However, many highly popular stocks suffered a sudden and brutal sell-off this week, a reversal that analysts have already dubbed the “momentum crash”.
The blow was particularly strong in the US, where strong-momentum stocks — those with the best recent record — tumbled 4 per cent on Monday, in the worst one-day performance since 2009, according to Wolfe Research. Only once before, in 1999, has such a rout afflicted momentum-fuelled smaller company stocks, according to investment bank JPMorgan.
“This is massive,” said Yin Luo, head of quantitative strategy at Wolfe Research. “This is something that we haven’t seen for a long time. The question is why it’s happening, and what it means.”
The flipside has been a dramatic renaissance for so-called “value” stocks — out-of-favour, often unglamorous companies in more economically sensitive industries. The S&P value index has climbed about 4 per cent this week and, compared with momentum stocks, enjoyed one of its biggest daily gains in a decade on Monday.
In essence, almost all of 2019’s hottest stocks have taken a hit, while the year’s most unloved dogs have enjoyed a roaring rally. Pravit Chintawongvanich, a strategist at US bank Wells Fargo, points out that the worst 12-month performers in the Russell 1000 equity index were up by the most on Monday, while the best 12-month performers were down the most.
This hurt many investors. The median long-short equity hedge fund — a strategy that strives to beat the market by picking winners — had lost 1.8 per cent in the month by the end of Wednesday, while computer-powered quantitative hedge funds have declined 2.3 per cent, and trend-following funds have shed 3.1 per cent, according to investment bank Credit Suisse.
Such a seismic rotation in investment “factors”, essentially the different groupings of stock market characteristics identified by financial academics, is rare, and reminiscent of a violent bout of turmoil that struck in the summer of 2007.
On August 6 2007, the quantitative investing industry, whose computer scientists used trading algorithms to systematically mine markets for money, suddenly and mysteriously saw their models go haywire, racking up huge losses for many “quant” powerhouses from Goldman Sachs Asset Management to Renaissance Technologies.
The turbulence lasted only a week and was later overshadowed by the financial crisis. But the event quickly became known as the quant quake, and remains etched in the memory of many hedge fund managers.
Now, as then, the cause for the sudden moves is a puzzle. Some have speculated that a big hedge fund or investment group may have been forced to pare back its positions, triggering a snowball that turned into an avalanche this week. But Mr Luo argues that the moves are big and broad enough to make it improbable.
More likely, analysts say, is that the momentum crash was triggered by the recent rise in bond yields. Momentum is often associated with trendy, high-growth companies, but over the past year more defensive “bond proxies” such as utilities and safer, resilient companies with strong balance sheets have actually enjoyed the strongest tailwinds, as investors have sought their safety and income amid concerns over the health of the global economy.
“By just looking at the price of the S&P 500 — not far from all-time highs — one cannot see the true state of equity markets,” Marko Kolanovic, head of quantitative strategy at JPMorgan, said in a note. “Most of the S&P 500 gains came from defensive sectors, stocks that investors tend to buy as a proxy for long duration bonds, and so-called ‘secular growth’ technology stocks. These stocks, incorrectly in our view, are deemed to be impermeable to economic woes.”
That illusion of invincibility appears to have led to investor “crowding” and extreme valuations for many stocks that are acutely sensitive to moves in bond yields, analysts say. On Monday, the 10-year US Treasury note dropped, sending yields 0.08 percentage points higher, and likely precipitating the violent reversal, argues Sarah McCarthy, a strategist at Bernstein.
The question is whether this is a passing market tempest — like the “tech tantrum” of 2017 — or the start of a longer-lasting shift away from the equity market’s biggest winners and into value stocks, which have largely underperformed since the financial crisis.
Mr Kolanovic reckons that the rotation will probably continue, but that the broader market will remain buoyant. Indeed, JPMorgan’s strategists now recommend investors bet on companies that are being heavily shorted by hedge funds, on the basis that many will be forced to ratchet back their positions.
However, the similarities to August 2007 unnerve Mr Luo, who points out that the quant quake was an under-appreciated early symptom of the far greater crisis that was starting to unfold at the time.
“This is a rare event, and might morph into something bigger,” said Mr Luo. “The 2007 quant crisis hinted at much bigger, more fundamental issues . . . [this sell-off] might also hint at much bigger problems.”
Value stocks, which typically have low multiples and stable fundamentals, significantly outperformed their growth counterparts recently, and a J.P. Morgan expert says the trend could continue into October, especially if the planned U.S.-Chinese trade discussions go well.
The iShares Edge MSCI USA Value Factor ETF (VLUE) climbed 1.8% on Monday while the iShares Edge MSCI USA Momentum Factor ETF (MTUM) slumped 1.7%. Data compiled by Bespoke Investment Group displayed this was momentum’s worst daily performance relative to value since its inception in early 2013.
Marko Kolanovic, global head of the macro quantitative and derivatives strategy team at J.P. Morgan, said his opinion is based on how he observes investor positioning, the current lack of performance of value names, and the loosening of technical flows last month in equities and bonds, which catalyzed a drop in yields, which hit extreme lows.
“Given that the S&P 500 is heavy in bond proxies and secular growth, we would expect higher upside potential in small caps, cyclicals, value, and Emerging Market stocks than the broad S&P 500,” Kolanovic noted.
In July Kolanovic wrote, “We think that the unprecedented divergence between various market segments offers a once in a decade opportunity to position for convergence.”
Kolanovic says there is now another hawkish divergence occurring, beginning last Friday with the record performance gap between large-cap companies and small-cap names. The strategist notes that his small-cap momentum indicator, based on a weighted one-, three-, six- and 12-month price momentum, reached its maximum negative reading, while simultaneously, the momentum signal for the S&P 500 was at its maximum positive reading. The only other time this occurred was in February, 1999, he added.
“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,” he wrote.
The JP Morgan quant experts believes that there could be a boost in manufacturing levels as long as trade talks go well.
For investors looking for pure value plays, well-known value ETFs like the iShares Russell 1000 Value ETF (IWD), iShares MSCI USA Value Factor ETF (VLUE), Vanguard Value Index Fund ETF Shares (VTV) and the Vanguard Small-Cap Value ETF (VBR) could be good choices to consider.
For investors who feel value is a long-term play, look to the Direxion Russell 1000 Value Over Growth ETF (RWVG). RWVG seeks investment results that track the Russell 1000® Value/Growth 150/50 Net Spread Index (the “index”). The fund, under normal circumstances, invests at least 80% of its net assets (plus borrowing for investment purposes) in securities that comprise the Long Component of the index or shares of exchange-traded funds (“ETFs”) on the Long Component of the index.
RWVG’s index measures the performance of a portfolio that has 150% long exposure to the Russell 1000® Value Index (the “Long Component”) and 50% short exposure to the Russell 1000® Growth Index (the “Short Component”). For more market trends, visit ETF Trends.It's been a bit of crazy week in markets and you wouldn't know it by just looking at the overall indexes as the S&P 500 notched its 3rd weekly gain and is close to another record high.
Zero Hedge being Zero Hedge (ie. the market doomsayers who love gold and bullets), has been all over this 'Quant Quake 2.0 since Monday:
- 'Quant Quake 2.0' Fallout: Nomura Warns Of "Horrific" Returns For Momo Stocks Ahead
- Something Big Is Taking Place Below The Market's Surface
- Quant Quake Goes Global Amid Momo Meltdown, Bond Bloodbath
- Goldman Warns 'Quant Quake' Marks The End Of Momentum Rally, Not A Buying Opportunity
- Stocks Soar Near Record Highs Despite Bond Bloodbath, Momo Meltdown
First, let's look at the performance of major market sectors this week:
As you can see, Financials (XLF), Energy (XLE) and Materials (XLB) all outperformed this week while Real Estate (IYR) got hit hardest.
This isn't surprising given that US long bonds (TLT) got hit hard this week as yields rose. In fact, Myles Zyblock, Chief Investment Strategist at 1832 Asset Management, noted on LinkedIn that TLT was down by over 6% which makes this a top 10 drawdown for all rolling weekly periods back to the ETF’s inception:
bond market jitters were overdone and that bond yields can back up given the record negative convexity hedging among mortgage funds and CTA positioning (front-running the mortgage funds).
Next, let's look at the top-performing stocks of the year which trade over $10 a share:
One of them caught my eye, Roku Inc (ROKU) which is a high flyer this year, up almost 400%. It's a stock I talked about when I discussed top funds' activity in Q2 and as you can see, after hitting a high of $176 recently, it got pummelled this week but is still up huge this year:
Among the top holders of this stock are Fidelity who bought in Q4 of last year and Renaissance Technologies which added a lot in Q2.
When a stock is up fourfold, it's safe to assume Big Boston (Fidelity) is taking some profits but who knows, maybe it sees it heading a lot higher.
All I know is the momo strategy (momentum strategy) has been on fire as quants and CTAs piled into it and that works until you reach the Wile E. Coyote moment:
Call it 'Quant Quake 2.0', call it whatever you want, these sell-offs can be brutal because there are a ton of hedge funds and mutual funds playing these crowded strategies and a lot of high flyers get killed when everyone heads for exit at the same time.
That's what happened this week, a lot of high flyers like Crowdstrike (CRWD) were among the biggest decliners this week:
Interestingly, among the biggest advancers this week, I saw biotech stocks I knows well, like Acadia Pharmaceuticals (ACAD) but also more stable healthcare names like Tenet Healthcare (THC) which had been out of favor this year before popping big this week:
Anyway, the other major event this week was the ECB and Mario Draghi's swan song, QE Infinity, which has most economists believing that Europe’s bond buying could run for years:
The shape and size of the European Central Bank’s new bond-buying program caught market participants off guard, with some now predicting it’ll be years until the euro zone is back to anything approaching normality.We shall see what happens in Europe but as Bloombeg notes, Germany’s fiscal paranoia can’t compete with Swedish debt angst.
Starting in November, the ECB will make 20 billion euros ($21.9 billion) of net asset purchases per month for as long as it takes for the euro zone’s inflation and growth outlooks to return to satisfactory levels. The purchasing will only end “shortly before” the next rate hike.
ECB President Mario Draghi pointed out Thursday that a major reason for the re-launch of net asset purchases was that inflation expectations remained consistently below the ECB’s target of just below 2%, but implored governments to deploy fiscal policy to supplement his actions.
This will be the second round of quantitative easing (QE) from the ECB, the first coming four years ago in response to the calamitous euro zone debt crisis.
Shweta Singh, managing director of global macro at TS Lombard, said the second round of asset purchases would likely have a “milder impact than QE-I, when borrowing costs were higher, fragmentation across the euro area was severe and domestic risks were far greater.”
“Crucially, there may be much less scope this time for the euro to edge lower and thus boost inflation expectations, while the pool of eligible assets that the ECB can buy has shrunk since QE-I was launched.”
The smaller increments but open-ended timescale of this second package (QE-II) surprised many, and was well below the 60 billion euro per month implemented at the beginning of QE-I in 2015. The open-ended commitment to continue until the inflation outlook improves carries several implications.
“The sequencing reference also signals that there would only be a short gap between the end of QE and the onset of rate hikes,” Ken Wattret, chief European economist at IHS Markit, said in a note Thursday.
“As we believe rate hikes are well down the line — we have the first DFR (deposit facility rate) hike only in late 2022, with an even later start increasingly likely — this implies a very long period of net asset purchases.”
The ECB forecasts inflation at 1.5% in 2021 which is still below what the ECB regards as “sufficiently close to, but below, 2%,” Berenberg senior European economist Florian Hense pointed out in a note.
“Thus, the ECB seems highly unlikely to raise rates before 2022 — unless inflation were to surprise a lot on the upside,” Hense projected.
“The asset purchase program could therefore last for at least 24 months with a total volume of 480 billion euros. More likely it will last longer.”
Barclays head of economic research Christian Keller anticipates that the asset purchase program will continue at least until the end of 2020.
“We expect the ECB will remain accommodative for a very prolonged period of time. We continue to think that risks to the EA (euro area) growth outlook are skewed to the downside and we do not expect core inflation will re-accelerate in the near term,” Keller said in a research note Thursday.
“As the euro area has arguably entered the mature stage of its economic cycle, we expect interest rates to stay low for a prolonged period and firms’ pricing strategies to remain conservative, and we believe fiscal policy is unlikely to reflate the euro area economy.”
Against this backdrop, Barclays economists do not expect businesses to feel immediate pressure to increase final output prices, and therefore project that core consumer prices are unlikely to catch up to levels consistent with the ECB’s medium-term price stability target. Keller thus expects underlying prices to remain on a “slow recovery trend.”
‘Strong signal for governments’
ECB policymakers unanimously agreed that fiscal policy rather than monetary policy should be the main tool to combat the economic downturn. The duration of the QE program may hinge on the willingness of national governments to take action.
Draghi on Thursday urged “governments with fiscal space” to act in “an effective and timely manner.”
Ana Andrade, Europe analyst at The Economist Intelligence Unit, said in a statement that the open-ended nature of the asset purchase program will be a “strong signal for governments, as it will increase their fiscal space.”
“It could potentially lead them to engage on more fiscal stimulus,” she added.
Hense agreed that by lowering funding costs further, governments may find it easier to finance a “modest fiscal expansion” and the policy might nudge countries with some extra fiscal space, such as Germany, to use it.
“On their own, purchases of 240 billion (euros) in one year will raise the balance sheet of the eurosystem by circa 2 percentage points of GDP (gross domestic product) in a year from its current level of close to 40%.”
That's all from me, don't let Quant Quake 2.0 or the ECB's QE Infinity rattle you just yet. It could be a sign of things to come but I'm more careful and will wait and see before jumping to any conclusions.
Below, Doug Ramsey, chief investment officer at the Leuthold Group, and Jason Trennert, chairman at Strategas Research, join CNBC's "Squawk Box" to discuss what they are watching in the markets as stocks sit close to all-time highs. Listen to Doug Ramsey: "The patient is old, and I don't think it can survive a transplant of this nature."
And J.P. Morgan’s chief quant, Marko Kolanovic, says a ‘once in a decade’ trade is upon us and the big rotation into value names should continue, and that stocks should move higher in October, and beyond, especially if the US-Chinese trade talks go well. He joins CNBC's Melissa Lee and the Fast Money traders, Tim Seymour, Karen Finerman, Dan Nathan and Guy Adami.
Obviously, Kolanovic thinks the flight from momentum is just starting but that remains to be seen. In my opinion, it's too early to jump to any conclusions even if it was a violent momentum sell-off this week.
Lastly, CNBC's Steve Liesman joins the "Squawk Box" team to report the on what European Central Bank's Mario Draghi is saying about his decision on interest rates and the world economy.