Volatility has returned to the markets, and growth stocks in information technology and health care have led the way down.
The chart above, from Deutsche Bank strategist Keith Parker, shows the extent to which fund positioning has helped fuel the recent decline in the stock market.
“Performance over the last month across stocks and sectors has been driven by position covering,” says Parker in a report on recent investor positioning and flows.
“Through the first two months of the year, long/short equity hedge funds and mutual funds were neutral the market but long growth stocks, which helped underpin outperformance through the January-February sell-off. The rotation out of growth and into value starting in early March hurt and funds were forced to unwind positions.”
Chart 2 provides a visual display.
Coming into the first quarter of 2014, growth stocks and the stocks with the highest hedge fund ownership were one and the same.
Funds were loaded up on health care, consumer discretionary, and tech stocks (think biotech and social media), and the “momentum” trade did well in February following the big market sell-off in late January.
As chart 3 shows, the growth stocks were significantly outperforming the broader market until March.
Since then, nearly all of the outperformance of this group of hot stocks has been erased as hedge funds have rebalanced, a process Parker says is probably almost over.
However, the unwind is “now spilling over to mutual funds that are still long growth, with outflows from growth funds exacerbating performance.”
In the week through Wednesday, April 9, equity funds oriented toward growth stocks were hit with $US1.7 billion of investor redemptions, following an outflow twice the size in the previous week. Flows into value funds, on the other hand, are accelerating — they took in $US1.9 billion in the week through April 9 and $US1.7 billion the week before. As one might expect from chart 1, consumer goods, utilities, and energy funds are receiving inflows while tech, health care, and financials funds are losing investor money.
David Kostin, chief U.S. equity strategist at Goldman Sachs, says the parallels between recent market action and that in March 2000, when the tech bubble burst, “dominated client discussions” last week.
“The current sell-off in high growth and high valuation stocks, with a concentration in technology subsectors, has some similarities to the popping of the tech bubble in 2000,” says Kostin.
“Veteran investors will recall S&P 500 and tech-heavy Nasdaq peaked in March 2000. The indices eventually fell by 50% and 75%, respectively. It took the S&P 500 seven years to recover and establish a new high but Nasdaq still remains 25% below its all-time peak reached 14 years ago.”
Kostin’s take is that this time is different, as broad market valuations are not as stretched as they were then, and the “bubbly” parts of the market account for a much smaller portion of overall market capitalisation today than then (tech accounted for 14% of overall S&P 500 earnings in 2000 but 33% of market cap, whereas today it accounts for 19% of both earnings and market cap).
While that is good news for the broader market, it’s still bad news for these high-flying growth stocks (see chart 4).
“The stock market, but not momentum stocks, will likely recover during the next few months,” says Kostin.
“Analysis of historical trading patterns around momentum drawdowns shows: (a) roughly 70% of the reversal is behind us following a 7% unwind during the last month; (b) an additional 3% downside exists to the momentum reversal during the next three months if the current episode follows the average historical experience; (c) if the pattern followed the path of a 25th percentile event a further 7% momentum downside would occur, or about double the reversal that has taken place so far; and (d) whenever the drawdown ends, momentum typically does NOT resume leadership.”
On average, Kostin says, the S&P 500 has risen on average by 5% following momentum sell-offs like this, led by value stocks that underperformed as growth stocks were going up.
Jan Loeys, head of global asset allocation at JPMorgan, takes a similar view.
“Each of the market reversals of the past few weeks has in common that they represented widely held positions — long equities, overweight small caps, overweight tech, underweight emerging markets, and short duration,” says Loeys.
“If there were greater worries about the economy or other downside risks, then we should have seen the dollar rise, credit and swap spreads widen, and emerging markets underperform. Correlations across risk assets should have risen. None of this has happened. There is no breadth to this sell-off.”
Of course, there are, as always, reasons to be cautious. Many of them may relate to an optimistic scenario — one in which the economic recovery accelerates, causing the Federal Reserve to tighten monetary policy and interest rates to rise.
“S&P 500 price-to-earnings is demanding excluding mega-caps and likely dependent on interest rates staying low versus history,” says David Bianco, chief U.S. equity strategist at Deutsche Bank.
Another factor to consider is corporate stock buybacks, which have restricted the supply of shares trading in the market.
“While everyone is focused on valuation and bubbles (to some degree rightfully so), the fact remains that the last few years have been supported by a low level of net equity issuance that has, all else equal, supported prices,” says Dan Greenhaus, chief global strategist at BTIG.
This trend may now be poised to reverse as buyback activity slows, given the fact that shares have become more expensive as the market has headed higher.
“Rather than investing in new equipment and structures, businesses have used their cash positions to buy back stock or to grow through acquisitions,” says Aneta Markowska, chief U.S. economist at Société Générale.
“This process, however, may be coming to an end. The ratio of the market value of equities to the replacement value of tangible assets (or the so-called Tobin’s Q ratio) has increased significantly in the past year and now stands at the highest levels since 2000. With equity values currently estimated at 25% above replacement value, expanding organically seems to make a lot more economic sense than expanding through acquisitions or stock buybacks.”
In other words, earnings per share have been boosted by a shrinking denominator — the amount of shares outstanding. If shares outstanding stop declining as buyback activity recedes and net equity issuance turns positive, it will put more onus on the numerator — the actual earnings — to propel earnings per share higher.
However, an acceleration in wage growth is a likely pre-requisite to Fed tightening. Such a development would pose a further headwind to earnings as corporations face rising employment costs.
“It now seems that what would be good for the recovery — higher labour income — will be detrimental for profit margins,” says Gerard Minack, principal of Minack Advisors.
“This may be a good year for the economy, but profits may fall short of forecasts.”
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