The Great Rotation Fascination

I’ve variously characterized 2021 as a year during which thematic swings and factor reversals became more norm than exception.

In the interest of accuracy, I should note that there are a variety of ways to measure such things. My assessment is amenable to quantification and, by extension, you could theoretically conjure charts that suggest such reversals have been more frequent and/or more acute in the past.

As ever, my point isn’t to make definitive statements that admit of no caveats — only to summarize key dynamics and make general statements about the prevailing market environment.

On Wednesday, JPMorgan’s Marko Kolanovic delivered a similar assessment in comments introducing the bank’s year-ahead outlook. “While the strong tailwind of recovery from the pandemic set an overall positive tone for risky assets, performance of various investment strategies was often thrown off by new COVID-19 waves leading to market volatility, steepening/flattening of yield curves and style rotations,” he wrote.

Describing what he called “the most acute source of performance beatdown within the equities space” over the past month, Nomura’s Charlie McElligott on Tuesday cited “thematic-, factor-, sector-, long- and short- ‘reversal’ behavior.” There have been other stretches in 2021 where one could have said roughly the same thing.

One key point that simply can’t be emphasized enough is the role of rates (and the curve) in driving those swings and reversals.

“The fact remains that realized correlations have seen very little passthrough from all the investor caution,” SocGen’s Vincent Cassot and Jitesh Kumar wrote, in their latest global equity vol outlook. In the course of elaborating on high dispersion, they noted a “salient bifurcation” between stocks that benefit from lower bond yields and those that don’t in the post-GFC era.

I could scarcely imagine a more wonderful euphemism than “salient bifurcation.” A less polite way to put it is just to say that bond proxies and anything even loosely connected to the years-old “duration infatuation” has run inexorably higher at the expense of anything and everything that might be described as “cyclical value.”

Earlier this week, I cited the bank’s Sandrine Ungari and Andrew Lapthorne in highlighting the chart (below), which illustrates the point better than perhaps any other I’ve seen.

If you slice the market into quintiles based on correlation with 10-year yields, you can see the “polarizing” (as SocGen put it) effect of the “slow-flation” macro environment and accompanying monetary policy accommodation.

Cassot and Kumar illustrated the same general concept using the beta of the ratio between financials and tech to the US five-year futures curve (figure below).

The visual shows “the amplitude of under-the-surface rotations,” they wrote.

Obviously, rates aren’t the only thing that matters when it comes to thematic swings and factor reversals, but as Cassot and Kumar emphasized, “of late they have been the most important factor.” Indeed, realized correlation appears tightly linked to bond volatility. Generally speaking, when bond vol is elevated, under-the-surface moves are larger.

All of that is crucial. If you want to understand what’s going on below the index level, you have to grasp the link with rates.

As important as the above most assuredly is, it’s not as entertaining for the average investor as other dynamics which help suppress correlation.

Cassot and Kumar went on to observe that as the industry moved towards zero commissions and retail investors’ footprint in markets grew, “the exceptional velocity of moves in some [meme] stocks create[d] ‘noise.'” Tesla, they wrote, “deserves special mention.”

Although it accounts for just over 2% the index, Tesla “accounted for 86% of the amount spent on call option premiums for the top 50 stocks in the S&P on October 25,” Cassot and Kumar said.

They went on to note that “since Schwab’s decision to waive commissions on retail trading, Tesla’s market cap has increased from $42 billion to $1.1 trillion.”

Read more on correlation, meme stocks and Tesla: Tesla Exhibiting ‘Classic Asset-Vol Positive Feedback Loop