Gallons of digital ink has been spilled over the past several months documenting the “bubble” in Min. Vol. stocks and Low Vol. products, and the extent to which that bubble may now be on the verge of bursting.
JPMorgan’s Marko Kolanovic, for example, has repeatedly called Low Volatility (and Momentum) stocks a bubble, going so far as to characterize the long Momentum/short Value trade as the next “XIV”, a reference to the infamous VIX ETN “extinction event” on February 5, 2018.
“The extreme divergence between Value stocks on one side and Low Volatility and Momentum stocks on the other side reached levels never observed in history, even including the tech bubble”, Marko wrote in September.
(JPMorgan, as of September 10)
Around that time, a sharp rise in Treasury yields off the August nadir catalyzed a series of multi-standard deviation style and factor rotations, including a momentum massacre that one popular cross-asset strategist called “one of the most stunning trades in modern market history”.
In early October, it seemed like things were set to get back to “normal” (as it were) when another growth scare came calling, sending yields lower again and putting the brakes on the burgeoning pro-cyclical rotation that threatened to wreak havoc under the hood in equities, where consensual positioning revolved around a variety of expressions tethered to the “duration infatuation” in bond land.
Fast forward another month to November and yields moved sharply higher on a combination of trade optimism, better-than-expected third quarter earnings in the US and decent economic data stateside. Headed into this week (which has been touch and go), the pro-cyclical rotation was back in full effect, and the likes of Kolanovic are calling for a continuation through year-end and into Q1 2020.
As alluded to above (and as detailed here extensively) much of this is down to the tight correlation between bonds and a variety of factors and styles. As SocGen’s Sandrine Ungari wrote earlier this month, there’s “bond risk everywhere”, especially in Min. Vol. As Kolanovic put it in another recent note, “low volatility crowding turned the conventional economics upside down: instead of high-risk stocks leading to higher returns, low-risk stocks consistently produced higher returns”.
Goldman takes this up in a note dated Wednesday.
“A recurring theme throughout most of the year has been the persistent outperformance of low/min vol, with the two largest Min Vol/Low Vol ETFs in the US (USMV and SPLV) garnering over $20bn of inflows over the past year”, the bank’s Jessica Binder Graham writes, adding that this “has led to concerns by investors around potential crowding particularly as the valuation premium of these funds increased concurrently”.
Yes, it most assuredly has “led to concerns”.
The charts below show the valuation premium expanding alongside the wave of inflows (left pane) and, crucially, the extent to which this has become one trade – these products’ beta and sensitivity to rates has risen for obvious reasons (read the chart header in the right pane).
Indeed, as Goldman goes on to point out, “the correlation between both funds and 10Y yields is sharply negative, with SPLV’s -77% being the highest on record.
You’ll note that there was an unwind in outperformance from Min. Vol. products starting in mid-2016 and continuing through the end of the year as yields surged following Trump’s election.
There’s a long way to go from where we are now on 10s (~1.88%) to where we were in October of 2018 (~3.25%). Clearly, an uninterrupted trek back to those levels is a far-fetched proposition, but the overarching point is simply to say that the trend of outperformance from these Low/Min. Vol. products may have come to an end. It’s now just a matter whether the bubble merely deflates, or actually bursts in earnest.
That, in turn, is likely to be a function of how quickly yields rise, assuming the recent bond selloff has legs and doesn’t simply succumb to souring macro sentiment or some new hiccup in trade negotiations.