September Of The Flying Pigs

Depending on who you listen to, September is either ripe for a continuation of the record rally in U.S. equities or a potential minefield thanks to risks emanating from, among other things, i) a fresh escalation in the trade war with China, ii) the likelihood of renewed turmoil in the Italian bond market due to a budget battle between the populist government and Brussels, iii) Mueller risk, iv) a dollar that starts to rise again after taking a mid-August breather.



Obviously, we’ve spent a ton of time talking about each and every one of those risks.

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But as far as the potential for a September rally is concerned, one argument is that the buy-side has some catching up to do and in the event that effort conspires with a reinvigoration in the long Growth/Momentum trade, there’s scope for further upside. Nomura’s Charlie McElligott has been pounding the table on this for quite a while.

“As discussed here for a few months, the enormous underperformance within the Equities fund universe is now perversely driving this latest market ‘melt-up,’ after hedge funds just last week had reduced their Equities ‘Net Exposure’ to one-year lows, while both Hedge- and Mutual- funds had reduced their Beta to ‘Momentum Longs’ down to only the 10th percentile just three weeks ago”, McElligott wrote on August 27, adding that from mid-August, “equities funds have been forced back into the market in ‘grabby’ fashion–thus the absurd +4.1% return in Nomura’s ‘1Y Momentum’ factor, along with a huge leap for both Hedge- and Mutual- fund ‘Beta to SPX’ last week (HF’s to 93rd %ile / MF’s to 87th %ile) and general ‘grossing-up’ behavior by the end of the week.”

That’s some Charlie-speak right there, but the gist of it is that after underperforming mightily thanks in part to Facebook’s late-July plunge and accompanying weakness in FANG+, what was working but stopped is starting to work again (got that?) and concurrently, equities funds are trying to catch up to the market. You can see this dynamic below:



Goldman spent quite a bit of time talking about this in their latest hedge fund trend monitor. “Volatility among the most popular stocks and low net leverage in a rising market have weighed on recent hedge fund returns”, the bank wrote, on August 20, before continuing as follows:

Despite outperforming earlier this year, our Hedge Fund VIP basket of the most popular long positions has lagged the S&P 500 by 118 bp YTD (7% vs. 8%).

Nearly 100 hedge funds owned Facebook as a top 10 portfolio position at the start of 3Q, keeping it atop our Hedge Fund VIP list and weighing on fund returns as the stock tumbled in July. Our VIP list of the most popular long positions has suffered large performance swings this year, lagging the S&P 500 by 500 bp since June. Declining net leverage as the equity market rebounded and outperformance of concentrated short positions have also worked against hedge fund returns.

Here’s Goldman’s point about declining net exposure visualized:


And as far as the short squeeze bit is concerned, the following chart shows two notable squeezes over the past three months:



Essentially, then, exposure was trimmed ahead of a fresh push to record highs, the “consensus” trades (i.e., long Growth and Momentum) briefly stopped working and the shorts backfired, leaving money managers to ponder whether it’s time to re-engage or risk falling further behind benchmarks.

That tendency to re-risk could well be amplified by the fact that volatility has remained subdued. After a wild February and March (or “wild” by post-crisis standards anyway), the swings simply haven’t been there:


So you decide: in light of the “non-stop risk event cabaret” and the minefield of geopolitical concerns mentioned above, would you re-engage to avoid falling further behind, or risk underperforming on the view that everyone who chases this headed into the U.S. midterms are pigs to the slaughter and lemmings to the cliff?

Then again, pigs have been known to fly over the past nine years, so if you mix those metaphors, the outcome needn’t necessarily be dead pigs.

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