There is a simple reason why all hedge funds with "relative value" or "deep value" in their names will soon be looking to change their moniker: stock picking no longer works, with the only strategy that matters, as implied correlation is now at the second highest level in history, is picking the time to leverage beta exposure and riding the broader market up or down. Alpha is now dead. as Barclay's head of quantitative strategies Matt Rothman says, "Indeed, it was hard to be a stock picker in the market for the last two months as the last two months have seen historically low levels of dispersion in stock returns. As shown in Figure 2, the cross-sectional correlation across all stocks in the market was at its second highest level last month (measured back to July 1950) and recorded its third highest level this month; there have never been to two months back-to-back with anything approaching these levels. To belabor the obvious and put this in perspective, current levels of correlation are higher than in October 1987, anytime during the Fall of 2008, either therun-up or the bursting of the Internet Bubble, or after 9/11. The reason this matters to all stock pickers — fundamental or quantitative — is because with stock return dispersions at all-time lows, it is extraordinarily difficult to be picking stocks." In other words, the danger of yet another systemic meltdown (or up), now that everyone is on the same side of the trade (and whoever isn't, is getting steamrolled), is higher than ever in history, up to and including May 6. And he, who has the greatest access to (risk free) leverage wins. Therefore look for all the "investment bank" hedge funds with prop desks and discount window access to once again post record trading days for the current and all future quarters until even they blow themselves up eventually and the Fed can do nothing to prevent it.
Full market commentary from Matt Rothman:
For us, this month was not so different from last month. Our models continued to work, marking two straight months of solid out-performance, ending our long spirit-crushing dry spell of underperformance. The broad market averages maintained their downward trajectory as investors continue to worry about the engines for future growth with implications from currency markets and various fixed income markets all leaking into the equities market. And so once again, it turned out to be all about quality.
This was good news for our portfolios – and for most practioners of quantitative stock picking – since our quantitative models give us positive exposure to the styles of investing that the market has been rewarding recently. Our models are built to gain consistent exposure to cheap high-quality companies with positive sentiment. In general, we like companies that are attractive on an earnings yield or free-cash-flow basis with strong historical profitability, improving margins and repeatable earnings that are also are being acknowledged by the market as having room to run through strong price momentum and improving earnings forecasts. Now, of course, it is high unlikely for any one company to have all of these characteristics going in their favor at any one moment in time, so our model is a way of picking and choosing stocks that come the closest to having it all. Moreover, not all of the characteristics described above are all positively rewarded by the market at any specific time.
What is noteworthy is that in recent months all three basic investment styles have all been working well. Cheap companies are outperforming expensive companies. High Quality companies are outperforming Low Quality companies. And companies with positive Market Sentiment have been outperforming companies with poor Market Sentiment. This lead to the relatively strong performance by our Quantitative models. In our long-only portfolio, 62.4% of our stocks beat their Russell 1000 benchmark. In the long-short portfolio, 66.8% of the longs beat the Russell 1000 and 47.2% of the shorts trailed the Russell 1000, for a combined stock selection hit rate of 57.1%. Last month, stock selection was strong for our model because the styles we liked were rewarded.
Let’s be clear, though, that this is not the same thing as saying this was a “stock picker’s market”. Indeed, it was hard to be a stock picker in the market for the last two months as the last two months have seen historically low levels of dispersion in stock returns. As shown in Figure 2, the cross-sectional correlation across all stocks in the market was at its second highest level last month (measured back to July 1950) and recorded its third highest level this month; there have never been to two months back-to-back with anything approaching these levels.1 To belabor the obvious and put this in perspective, current levels of correlation are higher than in October 1987, anytime during the Fall of 2008, either the run-up or the bursting of the Internet Bubble, or after 9/11. This observation holds across sectors, with the correlation of stocks within Materials, Industrials, Consumer Discretionary, Consumer Staples, Health Care, Financials, Technology and Utilities sectors all being at or very near historical highs.
The reason this matters to all stock pickers — fundamental or quantitative — is because with stock return dispersions at all-time lows, it is extraordinarily difficult to be picking stocks. The decisions that matters are related to style selection not stock selection. We are fortunate because the styles favored by our Quantitative model (Quality, Value and Sentiment) are being favored by the market. Clearly, the current levels of cross-sectional correlation are unlikely to be sustained and we fully expect to see them revert to their more normal levels in relatively short-order (weeks to months). Just as cross-sectional stock correlations converge towards 1 as markets falter, they tend to dissipate as markets rally. But we believe it would be unwise to read the chart above as a reason to think that a market rebound is due in immediate future. For example, market cross-sectional correlations remained highly elevated throughout the Fall of 2008 and first three months of 2009 (at levels above 50%) and came all the way in as the markets rallied. But we certainly do not believe that what sent the market rallying on March 9th, 2009 was not the unsustainable level of cross-sectional stock correlations. Rather, we hold it was a combination of wise and coordinated monetary and fiscal policies by governments and central bankers across the globe. Hence, we believe this is an interesting contemporaneous indicator about the current state of the market but it is ill-suited as a leading indicator of where the market is headed.