In Part I of this week’s commentary, we will feature Value-Momentum convergence play. Part II will focus on the heatmaps.
Value-Momentum convergence play?
- Our August 26th (2019) weekly Smart Beta Book concluded rather presciently with, “Finally, it’s important to put these YTD moves in the context of their longer term LTD history since the 3 worst ESBs at present (RV, DV, Size) are also the Top 3 best ESBs LTD (since Jan 2000) suggesting a significant opportunity when these factors revert back to their LT means.” From Aug 28th – Sept 16th Deep Value came screaming back ~+24% while PMOM crashed ~-23% vindicating that call.
- On Feb 3rd (2020), we noted that our Value was “starting to look oversold” & that “contrary to the oft observed January effect there were no reversals in sight as 2019 trends remained intact.” We also observed that based on bottom up aggregate ranks, Tech was looking rather stretched while Energy was oversold on technicals.
Needless to say “we witnessed a major Val-Mo rotation on Feb 5th with Value & Reversals up as much as +4% driven by the bounce in Energy vs PMOM & Risk down ~-2% ($ neutral) as the growthy tech names sold off” immediately following our note.
- On Feb 10th (2020), we presented “our rationale behind a potential Value-Momentum rotation” based on the “underperformance of Value over the last 3 years which has resulted in Value factor becoming “cheaper””. Indeed Value-Momentum spreads are historically wide as indicated in the below graph with the 1Yr and 3Yr spread Z-scores at -1.6 and -2.2 respectively. In fact the spread exceeded 20% within the first 6 weeks of the year. N.B. – These Z-scores are with respect to the full 20+ year history of the spread returns in our database.
- There is a huge dispersion in the valuation spread of the Value factor itself, as apparent from the graph below. In general, the valuation spread between defensive (low vol) + growth/ momentum vs cyclical names has (by some measures) exceeded the outlandish levels attained during the Nasdaq bubble (as emblematic in Tech vs Energy). Key catalyst for Value remains the steepness of the curve for Financials & Cyclicals to ignite. Additionally, Energy being in doldrums has been detrimental to Value on the long side but was a part of the reversal story last week. As the valuation gap amongst Value Longs vs Shorts narrows we should expect to see the Value factor outperform on an EMN basis (either because the multiples on the long side revert to the mean or more likely those on the short side compress).
- Historically, the largest momentum crashes have been precipitated by short squeezes at market inflection points (e.g., in the aftermath of the Nasdaq & 2008 crashes), whereas, we are now potentially looking at the exact opposite viz., a situation where the overbought Longs may actually lead the factor selloff in EMN terms.
- With Covid-19 rapidly spreading across Italy this weekend not to mention the series of infections in Japan & Korea, markets are likely to remain under pressure near term as they start pricing in a global (not just Asian) slowdown. Many small businesses in China & HK are likely to suffer or shutter while simultaneously squeezing the global supply chain. It became clear this weekend that the West is not immune to the contagion & that we may be looking at a global pandemic which is far from priced in given that US equities have been making new highs lately. The selloff last week led by the growth/ momentum complex could therefore continue (barring further central bank stimulus) which is one leg of our Val-Mo convergence call.
- The negative market contagion and uncertainty emanating from Covid-19 remains the chief risk to our factor rotation thesis. However, this will likely be counter-balanced by another wave of fiscal & monetary stimulus worldwide which would be the catalyst for Value & cyclicals to rebound significantly at the expense of overpriced bond proxies (aka the Low Vol bubble).
- It’s no surprise that markets have been inured to risks by the omnipresent global coordinated central bank puts. Episodic spikes in vol & dispersion are usually quite favorable for EMN factor investing although not necessarily on the long side (unless one happens to be positioned in the right factors). Stay tuned for more.
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