Month: September 2019

In the wake of the sharpest Momentum reversal in a decade, Goldman Sachs addresses some common investor questions on the equity market rotation and discuss what we expect going forward.

Q1: What just happened?

In the last two weeks, high momentum stocks have sharply underperformed what had been the equity market’s biggest laggards.

Our Momentum factor tracks the equal-weighted performance of the top 20% vs. bottom 20% of S&P 500 stocks ranked on trailing 12-month returns. The factor has declined by 14% since August 27, which marks the worst two-week return for Momentum since 2009 and ranks in the 1st percentile of historical returns since 1980.

Although the Momentum plunge has been sharp, it effectively only served to unwind the exceptionally strong Momentum rally in August. Momentum soared by 12% in the first half of August and 17% through August 27, a surge that in the last 40 years has only been matched in the late 1990s and late 2000s.

The reversal in Momentum captured sharp rotations in other equity factors and sectors that had become increasingly correlated with each other and Momentum through August. As Momentum declined, min vol and growth stocks also fell, while small-caps and value stocks outperformed. At the industry level, the Momentum reversal has reflected a rotation away from bond proxies like Utilities and secular growth stocks like Software & Services in favor of cyclicals like Consumer Durables that had lagged during most of the past 12 months. Unlike our other factors, our Momentum factor is not sector-neutral.

Q2: What caused the Momentum reversal?

A rise in investor crowding set the stage for the violent market rotations of the last two weeks.

As we highlighted in our most recent Hedge Fund Trend Monitor, trends of rising portfolio concentration, falling position turnover, and increased crowding have accelerated in recent quarters and increased the risk of a positioning-driven unwind. The rise in crowding helped drive the outperformance of the most popular stocks, which in turn further increased both leverage and the weight of these positions in investor portfolios absent any active offsetting adjustment.

Perceived improvement in US-China trade negotiations and better-than-feared economic data helped ease investor concern about an impending recession, lifting bond yields and sparking the market rotation. At the same time as headlines indicated progress in trade negotiations, the ISM Non-Manufacturing index beat expectations and helped lift our economists’ MAP index of economic data surprises into positive territory. The August jobs report, while slightly missing consensus expectations, showed payroll growth in line with the trailing 3-month average and gave no indication that trade concerns were having a critical impact on corporate hiring activity. These catalysts released the potential energy created by investor crowding, moving 10-year US Treasury yields from 1.45% to 1.75% and driving the equity Momentum unwind.

Q3: What should we expect for Momentum going forward?

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.

The chart below shows Momentum performance during 14 other 1st or 2nd percentile two-week Momentum reversals since 1980. The 14% Momentum decline of the last two weeks has already reached the median historical episode’s trough, which typically occurred about six weeks after the Momentum peak. On average, Momentum has traded flat during the months following similar sharp drawdowns, although returns in the initial drawdown’s wake have generally been weaker than Momentum returns in other environments.

One reason Momentum rarely rebounds following sharp drawdowns is that the composition of Momentum frequently changes. On average, nearly a quarter of the constituents in our Momentum factor are replaced during each monthly rebalance. Because of the sharp moves during the last two weeks, many of the stocks that currently comprise our high Momentum basket are unlikely to rank as constituents in the next rebalance at the beginning of October.

From a macro perspective, Momentum typically performs best during extended periods of macroeconomic and market consistency. Long periods against a consistent macro backdrop allow investors to rotate portfolios toward the stocks best-suited for those environments and benefit from those positions as the macro trends continue. Most recently, the environment of slowing economic growth that has characterized the last 12 months has tilted Momentum toward defensive equities and away from cyclicals. Momentum and cyclicals exhibited a similarly strong negative correlation in the weak economic environment of 2015 and early 2016. In 2H 2016, however, growth expectations rebounded, unwinding the Momentum trade. By mid 2018, as tax reform helped lift US economic growth, the correlation between Momentum and cyclical equities had turned positive, only to reverse again as growth slowed at the end of the year. 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.

Q4: Does the Momentum reversal signal the start of a rotation from Growth to Value?

The sharp outperformance of Value over Growth in the last two weeks has generated renewed investor focus on the possibility that long-suffering Value stocks reverse their multi-year trend of underperformance.

Even including its 13% rally since late August, our long/short sector-neutral Value factor (GSMEFVAL) has declined by 7% YTD and by 20% in the last five years. As Value stocks have underperformed, the valuation gap between the most expensive and least expensive S&P 500 stocks has opened to the widest level since 2000.

The dispersion of stock multiples has historically been a good predictor of the returns to be gained by Value investors, but has not been a useful signal for timing. At the start of 1999, for example, the top quintile of S&P 500 stocks traded with a P/E multiple of 30x, while the bottom quintile traded at just 12x. An investor buying the Value factor then would have watched it decline by 30% during the subsequent 15 months. If the investor had persisted with the strategy through the end of 2001, however, she would have realized a cumulative total return of 65% (18% annualized).

More than valuation dispersion, the path of economic growth will be the key determinant for Growth vs. Value performance in the near future. Historically, Value stocks have fared best in periods of very strong or very weak economic growth. In contrast, during periods of positive but modest growth, investors tend to favor the Growth stocks able to generate idiosyncratic growth in excess of the economy. These are often also periods in which investors favor the “Quality” stocks able to withstand a weak economic environment, even if those stocks carry a substantial valuation premium. For this reason, Value stocks typically underperform late in the economic cycle, as they have in recent months. Looking forward, even with valuation dispersion wide, investors will likely continue to favor Growth and Quality at the expense of Value unless the pace of economic growth changes materially, either rebounding sharply as it did in 2H 2016 or dipping finally into recession.

The US economy is rapidly deteriorating and currently experiencing a growth rate cycle downturn in employment, industrials, and inflation. One reason for the slowdown could be due to the oil and gas industry. 

Reuters reports oil and gas employment has declined as producers and service firms quickly cut back on operations due to a sharp decline in spot prices since 4Q18. 

Mining support activity jobs, a category that includes oil and gas drilling, as well as site preparation and well completion services, have been trending lower since Oct. 2018.

Latest figures from the Bureau of Labor Statistics (BLS) show Aug. employment fell 2% YoY, and down 4% from the peak. 

About 11,000 oil and gas jobs have been slashed from the prior year. These jobs were mostly in the “oil and gas support activities.”

As shown in a series of charts provided by John Kemp, senior market analyst of commodities at Reuters, the shale boom is cooling, and weakness will persist through 2020. 

The first chart shows US employment in mining activities, peaked on Oct. 2018 and has been trending lower ever since. 

The percentage change of US employment in mining activities on a monthly and 3-month average shows negative growth in employment is imminent. 

Diving deeper into the employment story, US employment in oil and gas support activities, which includes site work, casing, tubing, cementing, fracking, and acidizing appear to have stalled as well.

Growth rates from the prior year on a monthly and three-month average show support activity jobs have rapidly declined since the summer of 2018. 

And maybe the decline in oil and gas jobs is due to the plunge in the number of drilling rigs, which also started falling in late 2018.

Meanwhile, US crude production has hit record levels with more than 1.2 million barrels per day (bpd).

Crude production percent change from the prior year, monthly and three-month averages tell a different story, one where the growth in production is slowing. 

Kemp shows another chart where he expects the growth in oil production to continue falling through 2020, a reflection of a slowing economy and depressed spot prices for crude. 

Crude prices have remained depressed for 49-weeks, and since it usually takes 3 to 4 months of declining prices to translate into a drop in rig counts, it’s likely that more rigs will be brought offline through 2H19. This will ultimately slow employment in the industry and could be disastrous for President Trump in the 2020 election year, who routinely touts the oil patch as his economic success.

To push through QE and to preserve his legacy, Mario Draghi just started the countdown on central banking.

Apparently ripping a page out of Jean-Claude Juncker’s play book – “When it’s serious, you have to lie” – outgoing ECB President appears to have been caught in a big fat fib.

In his grand finale press conference today, Draghi unleashed QEternity (albeit with the limits we have noted), proudly proclaiming that “there was no need to vote” because there was “full agreement on the need to act” and a “significant majority” were for QE.

When pressed by a reporter, he further refused to detail who dissented – apparently signaling that it was as good as consensus as it could be.

“There was more diversity of views on APP. But then, in the end, a consensus was so broad there was no need to take a vote. So the decision in the end showed a very broad consensus.

As I said, there was no need to take a vote. There was such a clear majority.”

It turns out – he lied (just as he lied to Zero Hedge when he said there was no Plan B over Greece).

Bloomberg is reporting that in an “unprecedented revolt”, ECB governors representing the top European economies defied Mario Draghi’s ultimately successful bid to restart quantitative easing, according to officials with knowledge of the matter.

The unprecedented revolt took place during a fractious meeting where Bank of France Governor Francois Villeroy de Galhau joined more traditional hawks including his Dutch colleague Klaas Knot and Bundesbank President Jens Weidmann in pressing against an immediate resumption of bond purchases, the people said. They spoke on condition of anonymity, because such discussions are confidential.

Those three governors alone represent roughly half of the euro region as measured by economic output and population. Other dissenters included, but weren’t limited, to their colleagues from Austria and Estonia, as well as members on the ECB’s Executive Board including Sabine Lautenschlaeger and the markets chief, Benoit Coeure, the officials said.

Indeed, as Reuters adds, the QE motion was actually passed with a “relatively narrow majority” which explains why Draghi refused to take a vote as it would show that only Europe’s B and C grade nations – such as Italy, Spain, Portugal, Estonia, Malta and Cyprus – were for a restart in debt monetization.

As Bloomberg concludes, such disagreement over a major monetary policy measure has never been seen during Draghi’s eight-year tenure.

As Bloomberg adds, “Draghi’s decision to press ahead without such key support risks leaving Lagarde with a headache when she starts in November. She will need to decide whether to persist in a policy that has divided her Governing Council, risking further acrimony.”

The alternative would be to dial back the ECB’s current stimulus commitments, an approach that could provoke a market backlash.

Good luck dealing with that mutiny Christine!

By now everyone knows that over the past week, quants suffered an “incredible painful move” as Morgan Stanley put it, one which saw the worst ever 2-day return in the sector-neutral momentum factor…

… as momentum stocks sold off while an unprecedented wave of short covering lifted value/low-vol stocks.

What traders may not know, however, and what is emerging as one of the most remarkable aspects of the historic, multi-sigma quant crash is that as Morgan Stanley’s Rob Cronin points out today, spot outperformance/rotation of this size implies volumes should have been ~70% higher!

This also means that the market is increasingly prone to violent, destabilizing moves on increasingly lower volumes – clearly a function of declining market liquidity – until such a time as a handful of trades can launch a market melt up… or melt down.

More to the point, the relatively low volume traded on the offer side (0.3σ for cyclicals over last 2w) indicates the low conviction/low urgency of the move which nonetheless was tremendous. While this explicitly confirms just how little liquidity is present in the market, as a very low volume move has resulted in such an outsized outcome, these gapping rallies have less follow through typically, according to Morgan Stanley.

Another notable feature of the recent quant crash is that the overall hedge fund L/S ratio spread between Cyc/Def has barely moved in last 2w (from 45th %-ile to 47th %-ile). The L/S ratios are now roughly equivalent @ 1.7x apiece (Cyclicals high, given growth risks). In other words, macro and L/S hedge funds have not chased cyclicals during the recent upside, yet both were sellers of Cyclicals for the last 2w.

At the same time, cyclical shorts added in August were paradoxically not covered, despite the historic short squeeze observed in the past few days, as spot rallied in Sep. Why? According to Morgan Stanley, the MSSTHBC short base remained flat @ 2.8% of FF (42nd %-ile vs. 2Y) since start of Sep (vs. 2.5% at start of Aug), which begs the question: who was covering what.

The answer: while traditional, human-intermediated funds were largely dormant during the recent volatility, quants were main actor – net buyers of Cyclicals & sellers of Defensives each of the last 4 weeks. Though the z-score of these flows were modest, range bound between a max buying of cyclicals of +1x vs max selling of defensives of -0.5x.

Morgan Stanley’s summary:

• The 10% Cyclical vs. Defensive rally over the last 2 weeks (a 3.5σ event) is now at risk of unwinding. Why? Because “all the data points to a low conviction rally, directional HFs refuse to chase it and Quant/Systematic interest has waned in last 48h.”
• By contrast, the August Cyclical vs. Defensive unwind was very convincing – Cyclical short base grew by 12% & the move was flow driven (more volume traded net @ offer vs. bid). And HF positioning spread between CyC and Def, which was in its 65th %-ile in July (too high vs. weak growth data) massively unwound falling to its 45th %-ile – see HF L/S chart.

In short, this adds more fuel to the raging feud between JPMorgan’s quants, which as we noted believes this move can last for quite a while, and Morgan Stanley’s quants, who believe that the violent quant reversal is almost over.

Federal investigators, including the FBI, have been probing the ‘conduct and practices’ of Mithril Capital – the Austin, Texas-based venture capital firm co-founded by billionaire Peter Thiel in 2012, according to Recode – whose dramatic conclusion is that the investigation “threatens to destabilize the world of Thiel.” 

Whether that’s true remains to be seen, as Thiel “who has personally given a total of $300 million to the firm” is “tied to Mithril by reputation,” and “is not involved in Mithril’s day-to-day operations,” according to the report. In other words, Thiel’s name and money are attached to the firm and its $1.3 billion in AUM – but that’s about it. 

At the heart of the investigation is whether Mithril’s leader, Ajay Royan, committed financial misconduct by under-investing while raking in a likely $20 million in management fees, “an unusually large haul for a venture capital firm that each month has a smaller and smaller staff and therefore smaller and smaller expenses,” (and a figure disputed by Mithril). 

At least 75 percent of the firm’s management company is owned by a Cayman Islands limited company that is, in turn, owned in excess of 75 percent by Royan, according to legal documents. So some of that money is going to Royan directly as salary. –Recode

Make no mistake, the Recode report is a speculative hit-piece – and isn’t the first time they’ve written about the Thiel-linked venture capital firm, but there is a federal investigation underway as confirmed by Mithril. How it will affect Thiel – who has virtually nothing to do with the company, is anyone’s guess.

A federal investigation could subject Thiel, who has not publicly distanced himself from Royan, to new scrutiny as investigators put the firm he co-founded under a microscope. It could also stain the reputation Thiel has established for having a Midas touch in investing. –Recode

According to the firm, “This is a foiled plot by a self-serving ex-employee. There are no allegations from any government agency, or any [investor.] Nevertheless, our attorneys are in contact with government authorities in order to protect [investors], employees, and portfolio companies against any extortionate behavior.“

That said, Mithril appears to be going through a rough patch – to put it lightly: 

In the months since Recode reported on unanswered financial questions at Mithril, things have deteriorated, according to people familiar with the matter. The firm has lost staff and has adopted a more defensive posture. Two of the other managing directors at Mithril, Crystal McKellar and Jim O’Neill, recently left the venture capital firm in contentious exits, the people say — departures that until now haven’t previously been reported.

Those two departures, which are at least the sixth and seventh people to leave the investing team since the spring of 2016, have essentially stripped a shop with more than $1.2 billion in assets down to a bare-bones operation whose remaining senior full-time employees consist of Royan, CFO Anuja Royan (his sister), and a close ally named Paul Leggett.

That shrinking staff list might explain why the firm also removed the “Team” page from its website about two months ago, along with other tabs. Its entire website now features just a single substantive paragraph of information about the firm. –Recode

According to the report (and totally denied by all parties) is that Silicon Valley investment adviser, Cambridge Associates, is also poking around for signs of financial mismanagement. “The firm’s clients have invested millions into Mithril’s second fund, but some of those clients are now, in turn, frustrated with Cambridge Associates, which recommended that they invest in Mithril in the first place.”

Read the rest of the report here.