We’ve absorbed quite a bit of thoughtful inbound the last few days from clients on potential sector and factor rotations taking place. Below we offer some bulleted thoughts on this topic through both a cyclical and volatility lens.
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The internals of this week’s market move and hedging activity was probably a good example of the FAANG overhang and the second order effects of current style factor trends….We understand the short-term freak-out:
- These are Mega cap stocks that are huge index weightings and very volatile (Betas are 1.5-2.0)
- There is major performance dispersion right now in large-cap growth (if you short the wrong one and buy the wrong one, your year can turn upside down for anyone with a benchmark comparison)
- They are extremely volatile at the individual security level and dispersion is high as mentioned (there is a 31% performance divergence between FB & AMZN in just 3 months)
- It’s nearly impossible to sit-out a big run in the stocks because of their index weightings (shunning the FAANG isn’t realistic for most managers). Even a consumer analyst would have a big problem with no position in AMZN given its weighting in Consumer Discretionary and performance (+68% YTD).
Because of this market structure we observe a huge amount of reactionary, forced-hedging and chasing. Options markets are only able to absorb so much demand from investors trying to delta hedge and downshift their betas. The price of insurance sky-rockets in these situations...
- A week ago, at the all-time highs in QQQ, there was no implied volatility premium. Insurance then gets more expensive on the way down. The 1-mth "implied volatility premium" has expanded to +36% in QQQ and +35% in XLY (AMZN heavy). In XLK, it’s +32% as investors are forced to hedge this week’s tech bashing.
- It’s not just at-the-money vol that has spiked… Variance premiums have expanded. This means that implied volatilities in tail risk hedges has expanded even more than implied volatility at-the-money (the strike used for implied volatility premiums is at-the-money).
- Among the top 10 most expensive hedges in our global macro universe two months out (again at-the-money) are 3 directly-linked FAANG names. We show this divergence screen in a chart below.
- It’s not just at-the-money volatility that has spiked… Variance premiums have expanded. This means that tail risk hedging implied volatility has expanded even more than at-the-money implied volatility (think volatility surface skew).
Switching gears to looking at the same topic from a cyclical and factor rotation perspective...
- “Value” as a factor typically does well in QUAD 4, so if this rotation is underway it wouldn’t surprise us
- Short-term: Various constructions of “value” portfolios have greatly under-performed various constructions of “growth” and “momentum” YTD.
- Of course not all value portfolios are created equally. See the first chart below... Part of the beta-downshift over the last week has hit some constructions of value portfolios just as hard as "growth" and "momentum". "Low-Vol" and "Yield" portfolios are absolute winners in a down tape week-over-week (see the first table below). Macro tourists comment on factor rotation because they're watching price and volatility in the Russell style indices (where the most money is bench-marked). The Russell "value" indices heavily weight price-to-book ratios, a long-term performance-poor factor to construct value portfolios. Therefore, they're perpetually heavy in financials and other exposures that key off interest rates. And, we've written nearly on a daily basis on how interest rate volatility and volatility expectations (implied volatility & hedging costs) are still hovering at all-time lows right now.
- Long-term: Despite the fact that we know that good constructions of “value” portfolios outperform the market over the long-haul (and steamroll “growth” as a factor), we’ve gone through a decade long period where “growth” has outperformed even the best constructions of “value” portfolios (We show rolling 3yr cumulative returns for the Russell 3K “growth” index vs. “RAFI US Value” index – that index has crushed the market over the very long-term)
- Key Sector Implications: Plus consider the sector implications of concentrated factor exposures right now: 1) Info Tech sector of the S&P 500 has grown from 15% to 26% of the index in 10 years (19% to 26% in the last 5 years). In the Russell 3000 the sector index weighting has grown from 14% to 21% over that same 10Yr period; 2) MTUM is an ETF ticker in our table below for a broad-based Momentum strategy that, among a few other nuances, is constructed to own a basket of stocks with the highest 6 & 12-Mth price momentum in the mid and large-cap space. In just 5 years, the Info Tech weighting has gone from 5% to 41% of the portfolio currently. That is cyclical. 3) The Info Tech Weighting in the Russell 3000 Growth Index is 34% compared to 22% just 5 years ago.
With all that considered, a washout of this long-term out-performance for growth exposures wouldn’t be surprising to us. AND, it fits our GIP-Model view
- Conclusion: A rotation to value, yield, slow-growth exposures would fit a QUAD 4 set-up. And, although value is probably due for a relative out-performance wash-out even if you don’t claim to be a cyclical investor, we wouldn’t necessarily say today that financials are the vehicle to play that rotation (this could change) despite the fact that they've been a key reason for "factor rotation" headlines this week.
