Morgan Stanley Sees Recent Market Conditions As Reminiscent Of August 2007 Quant Crash, As "Don't Fight The Fed" Groupthink Trade Fizzles

Tyler Durden's picture

Something scary this way comes from Morgan Stanley's Quantiative and Derivative Strategies: "market conditions over the last two weeks are somewhat reminiscent of that during the August 2007 ‘Quant Crisis’. In only a few days, a number of quantitative long-short equity funds experienced unprecedented losses in seemingly ‘normal’ market conditions. We do not suggest here that the magnitude of hypothetical losses match those from 2007, however, there is little question that the rotation has drawn attention of many quant investors." In other words, the massive groupthink trade that we have been warning about for months may be about to claim its first mass casualties.

The just released report by author Charles Crow elaborates what many have been suspecting, yet few dared to voice: "Recent substantial factor movements in Europe have contributed to portfolio volatility and, in some cases, abrupt performance degradation. Portfolios positioned to take advantage of prevailing factor trends may have suffered substantially over the last two weeks." Is the groupthink trade about to end? If so, does that mean the funds will be forced to stop "not fighting the Fed" as this is really the only factor-driven trade that has made sense. If so, we have reached the critical point where being aligned alongside the Fed has no incremental marginal returns, at least for the non-Primary Dealers. This could promptly transform to a watershed event, especially since as Morgan Stanley adds, the market currently has "relatively low liquidity" to absorb the fringe moves.

More details from Morgan Stanley:

Recent substantial factor movements in Europe have contributed to portfolio volatility and, in some cases, abrupt performance degradation. Portfolios positioned to take advantage of prevailing factor trends may have suffered substantially over the last two weeks.

These rapid and significant reversals of factors returns have caught many investors – quant and fundamental managers alike – on the wrong side of a trade. The broad rotation also raises the question whether this represents the beginning of a secular shift back into Value at the expense of Momentum, Quality and Growth. Alternatively, the rotation may signify an idiosyncratic quant portfolio rebalancing in a market of relatively low liquidity.

We first seek to place the recent factor returns in a historical context. Exhibit 1 presents the weekly cumulative factor performance over the first three weeks in January. The fundamental factors span major investment styles, including Value, Growth, Momentum, Financial Leverage, Quality/Profitability and Free Cash Flow. To appreciate the recent rotation, also included is the cumulative performance of each factor over the entirety of the 2010 fourth quarter.

The above performance is sorted according to the week of January 17 – a period that realized substantial and persistent factor returns. It is evident that the rotation began over the week of January 10 (specifically, our data suggests it started on Tuesday, January 12).

The magnitude of weekly factor performance is striking and, in some cases, exceeds absolute factor performance over the entirety of 4Q10. Quant portfolios positioned to exploit recent Style trends – portfolios potentially long Quality (e.g., ROI), Growth (e.g., 1-Yr Est. EPS Growth), and Momentum (e.g., 12-Mth Price Momentum) – have endured violent reversals in many underlying positions.

For example, 12-Mth Price Momentum gained 4.2% over 4Q10, yet declined 5.3% during the week of the January 17. Negative Momentum is an indication of broad mean-reversion in the underlying equity market (e.g., ‘churn’). In fact, the factor realized -10.0% over the last eight trading days through unrelenting negative performance. The factor’s return exceeded 2-standard deviations moves on four of the last eight days. On January 12 – the first day of the ‘rotation’ – the factor realized -2.6% on a single day (a 3.9-standard deviation event).

All of this factor turbulence was realized in a range-bound equity market. Despite the recent increase in realized volatility, absolute levels remain historically low and expected short-term volatility has declined over the last ten sessions – see Exhibit 2. The VStoxx Index, which measures the cost of protecting against a decline in the Euro Stoxx 50 Index, declined 3.1% over the week of January 17.

Thus, market conditions over the last two weeks are somewhat reminiscent of that during the August 2007 ‘Quant Crisis’. In only a few days, a number of quantitative long-short equity funds experienced unprecedented losses in seemingly ‘normal’ market conditions. We do not suggest here that the magnitude of hypothetical losses match those from 2007, however, there is little question that the rotation has drawn attention of many quant investors.

Exhibit 3 emphasizes the magnitude of recent daily factor returns in Europe. The +/-1 standard deviation bands from September 1, 2010 to January 21, 2011 overlay the daily factor performance. A number of factor returns over the last two weeks have well exceeded 2-standard deviation events. Despite the recent uptick in market volatility, factor trends since the start of the rotation on January 12 have been largely one-sided.

One assumption from Morgan Stanley is that we are seeing an unprecedented-scale sector rotation by the quant community as it attempts to diversify from a huge one-sided trade, which is forcing many funds to get blown out of the water on loser positions.

Sector-level excess returns of the two factor quintiles suggest a relatively broad-based rotation. Book/Price, that has gained 5.8% over the last two weeks, has largely seen its ‘cheap’ portfolio outperform across sectors. Similarly, the ‘expensive’ segment across sectors has concurrently underperformed.

Analogously, the best performing names within our 12-Mth Price Momentum have largely underperformed consistently over the last two weeks, while the worst performing names have outperformed.

Although there are exceptions (e.g., -3.1% excess return within the worst performing Info Tech portfolio on January 13, which is a relatively concentrated European sector), the overall performance of the two factors appear to be driven uniformly across sectors. An open question is whether this rotation is short-lived or we will be experiencing a continuation of the reversal in the coming days and months.

A number of quant managers have adapted their approach to investing by taking into consideration risk factors such as crowded trades and abrupt style rotation. While some would have been less exposed to this recent trend, the environment continues to be challenging.

Our less than politically correct interpretation of this finding, as noted above, is that the traditional "don't fight the Fed" trade, validated by whatever combination of factors, is now on its last breath, and all those who are caught in it last, will see massive losses, ergo the scramble to rotate out. Should this indeed be the case, we are due for some material market turbulence as the quants struggle to reposition themselves in a market which is now longer dependent on the day to day whims of Ben Bernanke and the "Sack Frost" POMO dynamic duo. Lastly, if indeed we are in the midst of an August 2007-type of Hurricane, it is about to get a whole lot messier. Add Tom DeMark's expectations for an 11% decline in stocks, and not even the "Fed Frontrunners" may be able to continue the melt up at this point.

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TruthInSunshine's picture

Also, The Houston Chronicle had a nice propaganda piece on Sunday written by Paul Hobby, who is chairman of the Houston branch of the Dallas Fed. It addresses why we apparently need The Federal Reserve (the take-away is because monetary issues are soooo complicated), which is obviously laughable, and here's the Economic Policy Journal's fantastic response:

Is This the Best the Fed Can Do in Its Defense?


Salinger's picture

run away, I assume you mean from Ritholtz blog


good idea

JW n FL's picture

let the slide to 1100 begin... buy the dips yall!

rocker's picture

I think your right on the slide. Baltic Dry index keeps going lower, as pointed out by ZH weeks ago. Water Transportation stocks keep hitting new lows.

Where are the Dow theorist on this. Even Robo has to acknowledge something is not well. Make sure it's a big dip.

TruthInSunshine's picture

It's all good!

The Bernank is a magician, and he and his posse have BTFDers' backs.

The Bernank is a student of history, went to Harvard and MIT, taught at Princeton, and he has written a(n) (in)famous book on The Great Depression.

He would never allow a meltdown of equity, credit and derivative markets to take place, nor would he oversee a crash of the economy, with spikes in unemployment, foreclosures, bankruptcies, SNAP cards, welfare roles or other ill-effects to occur - forget about 2008; that was an anomaly.

The Bernank is a student of history and an academic of 1st tier quality and pedigree FTMFW!

aerojet's picture

Junked for welfare "roles."  If you're going to express an opinion that matters on here, learn to fucking write.

TruthInSunshine's picture

Ever hear of typos?

THEIR common.

SheepDog-One's picture

Tyler, I love your new ad sponsor dating site 'Plenty of Fish'? NICE!!

umop episdn's picture

Chasing the Bernank paper is playing bankster games on bankster home turf. No perp walks, no confidence, no players.

ak_khanna's picture

The markets will fall only when the banksters have eliminated all the short positions and only they themselves have positioned themselves to profit when the market falls


When an unexpected world event catches the banksters with their pants down and the softwares they use to rig the markets go berserk beyond their control.


Bob's picture

Jesus!  HAARP, chemtrails, DHS/FEMA, everything rolled into one massive theory.

Of course, being paranoid doesn't mean you're wrong . . .

papaswamp's picture the time period between crashes becomes shorter and shorter...

Sudden Debt's picture

The last "good times" where from 2001 untill 2005 and the crisis only lasted 12 months.

So if a crash occurs every 5 years knowing that we're already 6 in a crisis, the next crash is already 1 year overdue.


Neurolama's picture

You make good points.  I always laugh when I see your icon.  Who is that?  Where did you get it? - Jason B. Leach, CFA

alien-IQ's picture

USD dropping, Gold dropping Silver dropping market climbing. Oh yeah...makes perfect sense to me.

waiter...double scotch please. YES I KNOW IT'S ONLY 9:30 NOW BRING ME MY FUCKING SCOTCH!!!!

bingaling's picture

But I just read on bloomberg that global growth is about to take off at never seen before  levels.<sarc off>

Sudden Debt's picture


financeguru500's picture

Consumer confidence is only as low as Fox & Cnn say it is.

TruthInSunshine's picture

Pity those who have a world view rooted in anything the Lame Stream Media says, reports or writes.

eigenvalue's picture

hen we are about to see the a combination of soaring commodities and dipping equities again? By the way, if the Bernank should declare that QE3 would aim at buying stock on the open market, the whole analysis of this article would be irrelevant.

Cdad's picture

Apparently, L. Blankfein does not think much of J. Mack's indicated by the travesty little Miss Euro...ramping like the tramp she is.

The time to sell her, I think, has arrived.

papaswamp's picture

...'the ramp tramp'....catchy..I like it.

Bob's picture

I remember you spanking me for my brilliant flip-of-a-coin prediction that the tramp would recover from 1.29 . . . thought you had the other side of that bet, Cdad!

Cdad's picture

I may have taken the other side...and I'm still on it [although not in any position sense].  The currency is a joke...although maybe that is what you mean by "coin flip."

I am thinking of taking the short position Euro now...just watching for some conformation on the broader US equity market pretend rally being complete.  At that time, USD stud man becomes the "safety" play, of all things.

As for spankings, I rather doubt that.  Surely, not with a guy named Bob.

We shall see.  I am not shy about calling my actual positions.

Orly's picture

The safety play will again be the Swiss franc.

Cdad's picture


You may be right in a currency sense, strictly.  I don't follow the franc.  Let me clarify.

My point is safety in USD instead of US equity, the macro fund money move.  I suspect a lot of European money has moved into US equities in the last month or so...and it will find itself in dollars when the pretend rally ends and Euroland meets truth.  And when that happens, that is when I want to short little miss Euro. 

The EUR/USD chart is Flat Stupid.  While I don't really trade currency, I want this short position...and soon, I expect.

ATG's picture

In December and January were stealth Hindenburg Highs and Lows with <2.8% of NYSE volume, following the August Hindenburgs that heralded a -8% decline

Just sayin'

topcallingtroll's picture

Duh.  It's just a standard intermediate top I've been calling for the last couple of weeks.  They don't call me the topcalling troll for nothing.  I have a lifetime record of calling 50 of the last 10 intermediate tops in various markets.  Never miss a one.

DosZap's picture

What will a 60% jump in the VIX do to /In this scenario??

WSJ article is forecasting it.

Oh regional Indian's picture

The "market" seems like a drunk in a blind alley and the ability to only follow it's nose. The wall is coming up and the "market" is too bloated and drunk to scale it.

Not a good ending scenario. Systemic in-stability is in-evitable at scale. Too big usually explodes into manageable smalls. Always. Just see the universe with Super-Nova's a-plenty and not much "stability" in it's own time-horizon, eh?

Sounds of a Stuka come to mind....


Chuck Yeager's picture

Yikes...DON'T buy the fucking dip.

Caviar Emptor's picture

It's the "Hey, Pinocchio!" correction.

Fed getting increasingly cast in the role of 'Central Committee on Dis-information' as inflation begins to hit its stride in the midst of ongoing US economic downsizing. Now only 47% of working age Americans have full time jobs. With plenty still to go as State and local governments begin to downsize and Federal cuts will continue the trend. Ripple effects beyond that are sure to be felt. 

And that's on the domestic side. Internationally, US economic policy is already accepted as a central cause of world malaise as a net exporter of inflation, including food and energy inflation, and little else. Meanwhile BDI continues its 6-month slide and last night European and German manufacturing PMIs came in lower than expected for the first time in months. 

But The Fed continues to call for everyone on earth to rally to its noble cause, which it says is not the cause of world inflation. "Hey, Pinocchio! Inflate This!"


gloomboomdoom's picture

Keep tapping that foot... waiting for a collapse that will never come!

Caviar Emptor's picture

Sorry, it's already happened. US economic decline and world turmoil is now irrevocable. Stock market for pieces of paper can do what it wants, won't change the facts on the ground.

Ruffcut's picture

A collapse could come when ever the fed and their criminal partners can benefit from it.

I could support alot insolvent companies too, with free printed cash.

QE2 is a market pump. But might weaken without bagholders. Ponzi with no suckers is labeled, bad.

quasimodo's picture

In other news today, markets are green. All hail the magic conch shell

buzzsaw99's picture

Tom Hagen: The congress and president are definitely on wall street's payroll and for big money. The fed has agreed to be the squid's bodyguard. Now what you have to understand, Sonny, is that while the market is being protected like this it is invulnerable. Nobody has ever sold into a fed sponsored rally before. It would be disastrous. All the other five big banksters would turn against you. The sellers would be outcast. Even the HFTs would run for cover. So, do me a favor, take this into consideration. [/godfather]

Miles Kendig's picture

Looks like the quant world is just loving the wealth effect of the feds actions...