Barclays Quant Market Commentary: R.I.P. Flight To Safety
Yet another confirmation that there is nothing left in this market for sensible stock pickers, courtesy of Lehman's head of quant strategy, Matt Rothman: "In summary, the lower the quality of the company the more they are helped by an easy monetary regime. In these situations, true fundamental investors who focus on such banalities as valuations, free cash flow generation, the repeatability of earnings and the return on shareholder equity find themselves struggling to generate returns." What is sad is that Fed's tinkering with the stock market has now eliminated even that old-time staple trade: the Flight to Safety. Why be worried when the Chairman will not let anything fail? "Bluntly, if you had laid out for us the headlines at the beginning of the month, given them to us in full detail, and asked us to predict how our Quantitative Factors would have performed, well, we would have been wrong. Embarrassingly wrong.... There was simply no flight to quality among investors...Aside from the Euro/Dollar trade, there wasn’t much of a quality trade really anywhere in the market." And with QE3 planning already in process, this inverse flight to safety trend, where increased risk means an even faster scramble for the shittiest assets imaginable, will only get more pronounced. Welcome to the true new normal.
Market commentary from Barclays' Matt Rothman:
This month surprised us. Not because we weren’t expecting North Korea to attack South Korea (we weren’t). And not because we weren’t predicting the Euro zone to be embroiled in another currency crisis (we admit that wasn’t on our list of worries, but, hey, we are equity quants, not FX strategists). And not because we didn’t forecast another round of QE (again, we didn’t). The reason, we found this month so surprising is that even after all those events happened, the market’s reaction (or, more precisely, lack of a reaction) had us completely off-guard.
Bluntly, if you had laid out for us the headlines at the beginning of the month, given them to us in full detail, and asked us to predict how our Quantitative Factors would have performed, well, we would have been wrong. Embarrassingly wrong. After May and June of this year, we would have expected that another severe Euro crisis would have set off yet another general flight to safety – a flight to Quality. After all that is what happened just recently and many times before. Macroeconomic shocks (as well as Geopolitical shocks) send investors scampering into less risky assets, coming back in off the risk spectrum. In May of this year, as currency markets and equity markets swooned, our Quality index was up +2.3%. In September 2008, as Lehman Brothers collapsed and the equity markets shuddered, our Quality index was up +6.4%. In times of turbulence, investors seek safety, they run to Quality and that is well captured by our Quality index. But this month, despite seemingly major macroeconomic events, our Quality index was down. This is not what we would have expected.
But interestingly (at least to us), it is not that our Quality index mis-performed. In fact, no “safe” asset out-performed its risky counterpart. There was simply no flight to quality among investors. Treasury yields actually increased slightly for the month, though, effectively remained unchanged. Broad U.S. equity markets remain effectively flat. Aside from the Euro/Dollar trade, there wasn’t much of a quality trade really anywhere in the market.
In fact, one can argue the opposite: in many respects higher risk was rewarded. One of the ways to see this is in the strong performance of the short end of many of our baskets. Within Quality, we saw a number of “risky” cohorts outperform – particularly those with poor historical growth trends. Companies with strong earnings quality underperformed those with poor earnings quality. Companies with low relative profit margins beat those with high relative profit margins. Companies with low ROEs beat those with high ROEs.
We understand this primarily as both the result and anticipation of the next round of quantitative easing – QE2 taking hold. In essence, easy monetary policy dominated global macroeconomic concerns. Companies with poor historical growth trends, weaker margins and lower historical profitability rose as the availability of easy money became a reality.
After all, a company that is generating lots of free cash flow and has a strong balance sheet and strong cash reserves will not be particularly helped by a cheap money regime. They have all the money they need. Free money doesn’t help them. Instead, it is a company with low free cash flow and no cash reserves, one that is in relatively more need of cash that will be disproportionately helped by what is effectively free money.
In summary, the lower the quality of the company the more they are helped by an easy monetary regime. In these situations, true fundamental investors who focus on such banalities as valuations, free cash flow generation, the repeatability of earnings and the return on shareholder equity find themselves struggling to generate returns.