Those who have variously suggested that a rally based almost solely on a handful of tech names was vulnerable to a sudden reversal of fortune, were partially vindicated on Friday as the tech sector tumbled.
Fast forward to Monday and the tech turmoil has gone global in what one analyst calls “a buzz kill.”
Of course Goldman didn’t help matters last week with a note that suggested FAAMG has become synonymous not only with growth and momentum (not surprising and indeed probably not worth mentioning), but also with vol.
That creates considerable risks. Here are the important passages from the Goldman note for those who missed it:
A strong relationship with our Investment Profile (IP) Growth and Momentum factors should come as no surprise, but FAAMG also increasingly trades like Low Vol.Indeed, FAAMG’s correlation over the last 5 years to Growth, Volatility and Momentum sits in the 92%, 90% and 96th%ile. Further Momentum as a factor, in isolation, has built a valuation bubble underneath it not seen since ‘Factormageddon’ of last year.
Driven by the rise of mega-tech, Momentum, as a factor, has built a valuation air pocket underneath it creating cause for pause. Indeed, in our view, factor valuation is a useful gauge of investor sentiment and crowdedness. Our work shows that downside risk increases when factor valuations are stretched vs. history. To that end, the current P/E of the long/short Momentum factor is 1.8 std. deviations above its 3-year average, which is a level last seen in early 2016 just prior to “Factormageddon” – a period in late Q1:16 when the momentum factor fell sharply amidst a spike in factor volatility.
What is driving this? Keep in mind that momentum will regularly be re-populated with the strongest performers across the market. So it should be no surprise that Momentum is increasingly trading like Growth, which is up 15% YTD, the best performing factor by a wide margin. Currently, Growth has the highest correlation with Momentum when compared to other long/short factors and is in the 95th percentile vs. the last five years. In addition, the correlation between Tech and both Momentum and Growth is elevated vs. history, likely a reflection of investors seeking out secular opportunities not reliant on Washington DC’s policy agenda. See Exhibits 3-4.
While not exactly a Fields Medal worthy observation, we note that FAAMG is positively correlated with Growth and Momentum and this relationship has strengthened in recent months. The bigger anomaly, however, is that FAAMG is almost as highly correlated with Low Vol (as measured by standard deviation of 1Y daily price returns), which is not a characteristic typically associated with cyclically driven TMT names.
How can low vol create a problem? Investors are increasingly focused on “volatility-adjusted” returns as they are deciding which stocks to invest in. We believe low realized volatility can potentially lead people to underestimate the risks inherent in these businesses including cyclical exposure, potential regulations regarding online activity or antitrust concerns or disruption risk as they encroach into each other’s businesses. Mechanically, we expect that as the realized volatility of a stock drops, more passive “low vol” strategies buy the stock, pushing up the return and dampening downside volatility. The fear is that if fundamental events cause volatility to rise, these same passive vehicles will sell and exacerbate downside volatility.
In other words, this is the same damn self-feeding dynamic that people are worried about with other mechanical, programmatic strats that are levering up as vol. remains subdued.
The question is this: what happens when the virtuous circle of low vol., more buying, even lower vol., and still more buying reverses itself on a vol. spike and turns into a doom loop?
Here with more on this is SocGen’s Andrew Lapthorne…
The big news of the week, of course, came on Friday, with a sell-off in US Technology and related stocks. To give just one example, the Philadelphia semiconductor index (SOX) fell 4.2% on Friday, having at one time been down by more than 6.5%. Numerous technology and internet stocks saw similar performance setbacks.
The sell-offs themselves are not particularly unusual, but the uniformity of the prices moves all on the same day indicates a market driven by price chasing momentum, with investors heading for the door all at the same time. Indeed, those S&P 500 stocks which sold-off on Friday were almost all from the strongest performing decile over the previous 12 months (the r-squared on the S&P 500 line in the chart below is 85%). Within Nasdaq the relationship is even stronger at 95%.
Such a uniform sell-off strikes us as systematic, especially as the relationship weakens once you look at the broader and less liquid Nasdaq composite. For price chasing investors, Friday’s plunge serves as a warning; when it’s time to head for the door, you better move fast.