Late last year, JPMorgan’s Marko Kolanovic called for a continuation of an unwind in what is, quite clearly, a bubble in bond proxies and various other equity expressions associated with the vaunted “duration infatuation”.
The market’s love affair with bonds went into hyperdrive last August amid a recession scare (exacerbated by convexity flows) tied to new tariffs. In early September, yields snapped back higher in dramatic fashion, causing multi-standard deviation unwinds across factors. “[These] US equities factor reversals will go down in infamy… as one of the more stunning trades in modern market history”, Nomura’s Charlie McElligott declared, on September 10.
That factor quake looked like the beginning of the end for the massive valuation disconnect between, on one hand, momentum/min. vol./defensives, and, on the other, value/cyclicals. In other words, it looked as though Kolanovic’s call from months previous was starting to play out.
Fast forward to November, and a full-on, pro-cyclical rotation was in the works, as optimism around the US-China trade truce and the assumption that the lagged effect of dozens of central bank rate cuts in 2019 would begin to manifest itself in better economic outcomes.
Then came 2020, and with it, a pair of left-field macro catalysts: The assassination of Qassem Soleimani and the coronavirus epidemic. Each created a flight-to-safety, but that associated with the virus proved durable. It effectively undercut the reflation narrative and, at the least, delayed the unwind of the factor bubble mentioned above.
In a note out Wednesday afternoon, Kolanovic discusses all of this. “Our view that cyclical and value assets should rally in the first quarter was set back by the COVID-19 epidemic”, he writes, adding that “bonds, momentum stocks, and low volatility stocks rallied”.
The valuation spread between defensive and cyclical stocks is now 2X what it was during the peak of the tech bubble.
And this is manifesting itself in other places, too. That is: You can visualize it any number of ways. For example, have a look at the ratio of tech to energy:
That is quite something. And it’s mirrored all over the place.
When it comes to how this came about, Marko (quite literally) says he could write “a book” on the subject. But, by now, most investors steeped in the market zeitgeist can recite the narrative.
All of this comes back, in one way or another, to the same familiar list of factors (no pun intended). It’s the “slow-flation” macro environment combined with rock-bottom yields and Howard Marks’s “perpetual motion machine” dynamic. We’ve used the following passages from Marks more times than we care to admit, but they are always (always) worth another read, and because they are particularly germane in this discussion, we’ll use them again:
Organizers wanting their “smart” products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks. For example, having Apple in your ETF allows it to get really big. Thus Apple is included today in ETFs emphasizing tech, growth, value, momentum, large-caps, high quality, low volatility, dividends, and leverage.
The large positions occupied by the top recent performers — with their swollen market caps — mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise. Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced.
Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever.
Kolanovic reiterates the spirit of that assessment. What you see in the first visual above (and what is evidenced in countless other, similar performance and valuation disparities), was driven by the following factors, Marko writes:
- Central banks pushing global yields into negative territory (propping up defensive and secular growth/tech bond proxies);
- Growth of passive indexation and momentum strategies (pushing assets into momentum, mega caps and low volatility stocks);
- As well as flows based on simplistic ESG schemes that just exponentiate the same crowding trends (e.g. very high correlation of ESG with low volatility, large size and momentum scores as well as sector concentration in tech)
I would remind folks that there is exactly nothing controversial about that assessment. You have doubtlessly heard that position (or, more likely, some straw man purporting to be that position) attacked by those with a vested interest in one or more of the dynamics in play, but it isn’t in doubt. It is reality. Kolanovic is correct. Howard Marks is correct. It is what it is. And for the McElligott fans among you, Charlie has made countless tactical trade calls based on the daily, weekly and monthly ebb and flow of this same dynamic.
For his part, Kolanovic doesn’t mince words when it comes to sticking with his contention that, eventually, this will correct itself.
“Value stocks are typically on the other side of all of these trends that inflated this bubble”, he says. “We caution investors that this bubble will likely collapse. This time is not ‘different'”.