For those with short memories, markets don't always go up and aren't always liquid enough to allow you to exit before the bagholders. As detailed at the time, during the week of August 6, 2007, a number of high-profile and highly successful quantitative long/short equity hedge funds experienced unprecedented losses.
The losses at the time were initiated by the rapid unwinding of one or more sizable quantitative equity market-neutral portfolios.
Given the speed and price impact with which this occurred, it was likely the result of a sudden liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to margin calls or a risk reduction.
These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses on August 9th by triggering stop-loss and de-leveraging policies.
It was a harrowing time for markets then and, somewhat ominously, Morgan Stanley's Quant Strategies group is worried that groupthink has infected the quant markets once more as Chris Metli warns that factor volatility has spiked, and for some factors like Momentum this has been one of the most rapid moves higher in volatility on record.
Factor volatility is not yet at the peaks seen during the Feb 2016 or October 2018 unwinds, but it’s getting there, and it has eclipsed (and risen faster than) the volatility seen during the August 2007 factor unwind.
QDS noted last week that something wasn’t quite right in the market, and given these violent swings in factors that judgment still holds today. What’s going on? At the core it is crowded positioning and valuations across factors and sectors (i.e. Growth and Defensives over-owned while Value and Cyclicals under-owned).
And despite the increased volatility, positioning doesn’t appear to have become too much cleaner in recent days.
Over the last two weeks, rotations between the super-sectors of Cyclicals (including Financials), Defensives, and Tech have accounted for a historically-high share of total dispersion between stocks in the S&P 500 (prior similar peaks were Oct 2018, April 2018, and June 2017).
This fact means that investors who have been positioned wrong way on any of these three legs of the market (as many are) have been whipsawed.
There is really no way besides positioning to explain the recent swings, particularly in Cyclicals vs Defensives. Tuesday’s short squeeze driven rally brought a healthy bid to Cyclicals (which made sense) but then Wednesday that performance reversed with a flight to the ‘safe havens’ of Defensives and Tech – despite a 80 bps rally in the S&P 500.
As John Storey on the MS Custom Basket team noted “no time in the last 5 years has a 3.5% move in MSZZCYDE been followed by a reversal of -2% or more the next day. We got that today.” Investors are getting chopped up between covering underweights / shorts and flocking back into old favorites.
This back and forth threatens to push portfolio volatility higher and drive a deleveraging / degrossing. That is exactly what happened starting in 3Q into 4Q last year.
While a risk reduction is likely in the cards given higher volatilities, the pace of L/S deleveraging is likely to be more gradual than in 4Q18. Why? P/L, timing, and magnitude/duration of the shock. In the 2018 unwind P/L for many funds had turned negative, it was later in the year, and portfolio volatility had been rising and elevated for some time. In 2019 many active managers and HFs still have materially positive P/Ls that provide a buffer before deleveraging becomes forced, it is earlier in the year, and at least so far volatility has only been elevated for a short period of time. Of course any fundamental deterioration in crowded positions could change these dynamics, but for now there is less risk than there was heading into 4Q 2018. While that may not be enough to stop deleveraging, it does mean it will be more gradual.
Given that positioning is still imbalanced QDS favors shorting over-owned names (i.e. Growth and Tech) as these should prove underperformers in either a more convincing bull or bear market. Selling Momentum is similar but may be harder without a strong market-bearish view given that a lot of the volatility is coming from the short leg of the trade where positioning is light and susceptible to squeezes.
At the index level it is evident that the market can go up faster than it can go down given light positioning and high levels of short exposure. That doesn’t mean the market can’t go lower, just that it will be a trend not a gap.
With equity investors still clinging to a Fed driven “bad is good” mindset (see the gap between stock and bonds above) and underestimating the structural impacts of trade disruption and economic nationalism, QDS favors leaning short equities but protecting against squeezes with upside calls.