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Below its sleepy surface, a breakdown in momentum trades rattled the floor of the U.S. equity market this week. But before getting too worked up about damage to the math whizzes who bore the brunt, it’s worth considering some of the episode’s happier implications.
While it doesn’t sound like it, in this topsy-turvy market, trouble for high-flying stocks isn’t altogether bearish. That’s because plunging Treasury yields have been persuading hedge funds for a while now that a recession is at hand, luring them into defensive industries like utilities and real estate. As those shares were bid up, companies like American Tower Corp., a REIT, and household product maker Ball Corp. started dominating momentum portfolios.
Then something unexpected happened. Treasury rates reversed course, jumping faster than any time since Donald Trump was elected president. Whether it was improving economic data, signs inflation was back or a relatively quiet week on Trump Twitter, suddenly the rationale for defense was under siege. In a market that didn’t go far, both Ball and American Tower plunged more than 7%.
“We may have gotten to peak recession fear last month,” said Steve Chiavarone, a portfolio manager with Federated Investors, which has over $500 billion in client assets. “The market has been discounting whether or not the expansion continues — we’ve been trying to do that for 12 months. What it’s telling us right now is we’re more optimistic about how it’s going.”
One way of framing the events is that the economic signal from stocks just got a leg up — for now — over the one flashing from bonds. A debate has raged all year between the asset classes over the direction of the economy, with falling and inverting rates in Treasuries signaling gloom, and the resiliency of the S&P 500 — up 20% in 2019 — suggesting otherwise.
Vestiges of skepticism have lingered in equities — hence the defensive nature of its rally. But that began to crack this week. Banks led the advance, gaining almost 8%, while energy, industrial and commodity companies surged more than 3%. That added to the pain of hedge funds, who had shorted offensive industries as aggressively as they bought defensive ones.
Before this week, as fast as stocks had risen, so had bonds, sending U.S. 10-year yields below 1.5% at the end of August in the strongest rally for Treasuries since 2008 as central banks around the world eased, growth appeared to slow. Lower for longer became the mantra and equity investors positioned for such a scenario, piling into stocks coveted for their high dividend yields and defensive characteristics.
Whether it was data showing a buoyant U.S. labor market and services sector, a surge in corporate issuance or simply an overbought Treasury market, the change this week was jarring. Even with the Federal Reserve poised to cut rates next week, a more conciliatory tone over U.S.-China trade and hot inflation exacerbated the unwind, and a swift backup in yields rattled what had become the safe stock trade.
Two views on what caused the change:
Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets: “As we approach the Fed and as we have realized the ECB rate cut, the pendulum of expectations is now swinging back in favor of another round of reflationary pressures. And the fact of the matter is that the rally got overextended in August. And as cooler heads prevail and as people start to project toward the end of 2019, it follows intuitively that we would see a bit of a correction higher in rates.”
Michael Sheldon, chief investment officer at RDM Financial Group at HighTower: “Sometimes when you stretch a rubber band so far to one side, it violently snaps back. Sometimes when all investors are on one side of the boat — markets and individual investments can become extreme. At some point, you don’t always need a catalyst, but things reverse and you get a reversion to the mean.”
By some definitions, this was worst week in a decade for quantitative momentum strategies, which bet that recent winners will keep on winning, and the best week for beaten down value stocks, according to Bloomberg measures. While some blamed crowding for the unwind, much of the onus was also placed on the bond market.
Over the past 12 months, utilities, real estate and consumer staples stocks have gained more than any other sector, each up more than 10% while the S&P 500 has risen less than half that. These classically safe sectors became synonymous with momentum. After this week’s spike in yields, bond-proxies just don’t look as attractive.
“The size of the move in the bond market over the last week has been breathtaking,” said Alan Adelman, a senior fund manager at Frost Investment Advisors, which oversees $4.7 billion. “That indicates to us that the risk appetite perhaps is increasing. It’s definitely a bit more of a risk-on type of scenario.”
Areas of the market that were shunned before are now seeing interest. The Russell 2000 Index rose almost 5% this week while the S&P gained closer to 1% — the best week for small caps relative to large since the 2016 U.S. presidential election. An equal weight version of the S&P that gives smaller companies the same clout as, say, Apple Inc., beat the more popular market-cap gauge by the most in almost a year.
For equity hedge funds that have crowded into favored momentum names and shorted unloved areas like energy, the change of pace has meant pain. A Goldman Sachs measure of the most shorted stocks rose more than 8% this week, the most since the 2016 presidential election. According to Morgan Stanley’s prime brokerage unit, a hedge-fund alpha gauge notched its second worst showing of the year on Monday.
But to those watching market internals, the shakeup is a good sign. Roughly 70% of companies on the New York Stock Exchange now trade above their 50-day moving averages. As more stocks participated, the cumulative advance-decline line — which measures the number of daily gainers minus decliners — touched a record this month.
That view will be tested next week, when the Federal Reserve delivers its policy decision. The stock market is at mercy of the bond market, according to Joseph Mezrich, head of U.S. quantitative analysis at Nomura Instinet LLC. Where interest rates go from here is key to any view on whether or not this week marked a protracted pivot.
“What drove the change this week is what happened in the bond market,” Mezrich said by phone. “So the question is, what happens going forward? Tell me what’s going on in bonds and I’ll tell you what’s going on in these factors.”
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