One risk headed into earnings was the abatement of the low bar dynamic.
Low bars are easy to clear, so while it’s comforting on many levels to see earnings revisions inflect for the better (or stabilize), it means the hurdle is higher for corporates come reporting season. I warned on this weeks ago, and it’s starting to bite.
“That longtime crutch of equities markets — the fundamentals of EPS / revenue ‘beats versus low-bar expectations’ — has been flipped on its head,” Nomura’s Charlie McElligott said Thursday. “Recently, we’ve seen [an] earnings revision upgrade dynamic acting as a headwind, particularly in the crowded market leadership of growth tech, comms services, story stocks and A.I. themes.”
One particularly instructive statistic in that regard is the punishment meted out to Info Tech companies which beat on the bottom- but not on the top-line. When it comes to tech and comms services, the market can be hyper-sensitive to revenue versus malleable profits. Sales are just sales. Profits can be anything you want them to be.
“Crowded growth [shares] and tech longs are actually putting up good enough numbers but still not being rewarded by the market, especially when EPS beats but revenue misses,” McElligott noted.
This matters. These are your consensus longs. Your hiding places. Your 2023 alpha generators. Your hedge fund favorites.
Two Nomura baskets tracking growth longs and the most crowded hedge fund names just suffered ~7% six-day drawdowns, a 2.5 standard deviation event on a one-year lookback.
“You can feel it in the PNL [and] you can see it in the intraday behaviors and end-of-day performance of late,” Charlie went on, noting that “a bunch of the stuff that’s been high Sharpe over parts of the year has recently turned high vol.” That’s bad news. “BIG $HARPES, BIG PROBLEM$,” as he put it. Even for discretionary cohorts, volatility is an exposure toggle (to employ Charlie’s favorite phrase), so… commence the de-grossing.
He used a Nomura basket of “second-order” A.I. beneficiaries — A.I. stocks not called Nvidia — to illustrate the point. “This custom basket was +28% in the span of two months from mid-May to end-July as the A.I. mania spread,” he wrote. Over that period, realized vol receded to a six-handle.
As the figure shows, 10-day realized has now quintupled, while 20-day rVol has doubled.
Why is this important? Well, again, these themes, sectors, styles and stories are (or were) the source of your 2023 profitability. They were “a crowded hiding place,” as Charlie put it, and they “chew[ed] up a lot of long exposure, especially in a challenging year of index level directional returns” dictated solely by the vaunted “Magnificent 7,” which comprised 30% of S&P 500 market cap headed into earnings season.
The de-grossing is “reverberating across all S&P sectors,” where that means some this year’s worst sectors managed to outperform midweek.
Panning back out, the implications for systematic flows are potentially bearish. If single-name vols jump, that could elicit an expansion for index realized vol, which could in turn dictate mechanical de-leveraging from vol control cohorts.
The figure above shows vol control’s estimated allocation down meaningfully from the highs seen at the end of July, when the multi-month glide lower for rVol engendered a steady buildup of equity exposure.
Finally, McElligott said a “general fattening of tails,” inclusive of late-cycle jitters and, of course, geopolitical concerns, has spoiled the party for vol sellers with the exception of overwriters, who’ve obviously benefited from the equity correction.
“Previous periods of high Sharpe returns in systematic vol selling are now being rinsed out,” Charlie wrote, describing another example of “BIG $HARPES, BIG PROBLEM$.”
Bringing it back to discretionary investors (i.e., active managers, etc.), McElligott said that if you ask him, “further breakdown is likely dependent on the fundamental / active side of the equities universe and an extension of this recent earnings behavioral shift towards longs, especially as PNL management psychology moves into year-end protection mode.”
Now that the S&P has retraced the entire June post debt-ceiling breakout, joining mid and small caps which retracted (and then some) their rallies weeks ago, I think it’s now official: we all owe Mike Wilson an apology.
The Nasdaq 100 is up 25% since Wilson took profits on a well-timed tactical long instituted in mid-October 2022 (took profits December of 2022). I like Mike’s stuff as much as (and, I’d wager, a lot more than) the next market participant, but investors would do well to disabuse themselves of the tendency to declare bears “right” when stocks correct after a huge rally. You can observe a similar dynamic with the legions of unfortunate souls who still read the bear blogs that rose out of the ashes of the GFC. Occasionally (e.g., during the March 2020 crash) you’ll see people claiming those blogs were “right.” The harsh reality is this: If you predict imminent (or semi-imminent) downside and you get lots of upside instead, the odds of equities correcting to meet your downside target (implied or otherwise) later become vanishingly small, pretty fast. Wilson was wrong. Period. I love the guy, but no apologies are owed. If you listened to him, you missed the best first half for the Nasdaq 100 in recorded history. Let that sink in.
Also (because I realize this isn’t always apparent to folks), Charlie is on a different side of the sell-side (if you will) versus Wilson, David Kostin, Savita S., etc. The reason Charlie’s stuff is so dynamic, colorful and just generally “ear-to-the-street” is because he’s in the thick of it. In the proverbial trenches. That’s one (among many) reasons people love Charlie. His stuff comes straight from the frontlines.
He also shines light on what recently have been the largest and most important short- and medium-term flows, even eclipsing share buybacks.
His insight is much appreciated.
+1
The Nasdaq 100 is the only index you can say that about. The S&P 500, 400 and 600 (and others) are all back into the range stretching for most of 2022 and H1 2023. Yes, one could have tactically traded the swings and done well, if that’s you’re style. Or been smart enough to jump of the AI mania, while it lasted. But many, including me, expected these pullbacks to be bought before a resumption to new highs, while he warned of false breakouts. Maybe we’re near the low and we’ll get an oversold bounce into positive seasonality for a rocket ship to new highs, but I am apologizing to the man. I thought his bear call was crazy and now it seems much less crazy.
Yeah, I mean Mike’s the opposite of crazy. He’s Mr. Rational. And that’s sometimes the problem: Wilson’s an eminently rational guy (or at least when he’s talking about equities) whose job it is to forecast a notoriously irrational asset. 🙂
Now that etf carry lion share of bonds – bonds r increasingly irrational too – kite strings?
H-Man, if you trade flow on a short term horizon, Charlie is the bible. Stretch that horizon and Wilson becomes relevant but not a prophet. Go long on the horizon and you buy index funds sending Charlie and Wilson to the trash can since the commentary is no more than noise. Probably better to evaluate the wisdom based upon your horizon.