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Equity Risk Monitors — March 25, 2024

Equity Risk Monitor Highlights | Week Ended March 22, 2024

  • Momentum begets momentum, until it doesn’t
  • European risk’s recent decline drops it to near a 10-year low

Momentum begets momentum, until it doesn’t

With market leadership remaining consistent, returns to the Medium-Term Momentum factor have been unusually strong over the past three, six and 12 months across all regions we track closely. Most notably, in both the Developed Markets ex-US model and the Worldwide model, the risk-adjusted three-month return — measured as the return divided by the expected volatility at the beginning of the period — was over three (that is, it was three standard deviations above zero). In the US, Europe, Asia ex-Japan, Japan and Emerging Markets the three-month risk-adjusted returns were all higher than 2.5, and no region has seen a negative three-month return. For the WW4 model, the quarter-to-date 5.1% return, should it remain stable, would be the second-best quarter in the history of the model, exceeded only by the 8.6% return in the fourth quarter of 1999.  

The magnitude of Momentum’s return was also higher than that of any other factor in most regions for the one-, three-, six- and 12-month horizons, suggesting it is likely to have had a large impact on portfolio returns.

Still, caution is in order. After that stellar quarter of Momentum performance in 1999, five of the next 8 quarters saw negative returns, and it took until the second quarter of 2002 for the factor to regain its previous high-water mark.  Over the full history of the model the serial correlation of quarterly Momentum returns is slightly positive, but the best performance tended to follow quarters in which returns were in the third or fourth quintiles relative to history.

See graph from the STOXX® Developed World Equity Risk Monitor of 22 March 2024:

European risk’s recent decline drops it to near a 10-year low

European stocks, as measured by the STOXX® Europe 600, have seen one of the biggest three-month drops in risk among the countries and regions we track closely. Medium-horizon fundamental risk fell about 24% proportionally, from 12.9% to 9.9%, while short-horizon fundamental risk dropped from 11.2% to 8.9%, a 21% decline. At both horizons predicted volatility is nearing at least a 10-year low.

See graph from the STOXX Europe 600 Equity Risk Monitor of 22 March 2024:

The following chart is not included in the risk monitors but is available on request:

We look at the drivers of the change in risk in a number of ways meant not only to better understand the change in benchmark risk, but also to help investors know what to look at to determine sources of change in active risk.

First, we can look at a decomposition of the change in risk based on the major components of the factor model. Here we can see that the three-month decline was driven exclusively by lower factor volatility.

See graphs from the STOXX Europe 600 Equity Risk Monitor of 22 March 2024:

That leads us to dive into which factors may have driven that decline.

The chart of the components of risk shows that market risk, as the largest component of total risk, was the major contributor to the decrease. However, currency risk fell substantially (15% and 25% at the short- and medium horizons respectively, both near their 10-year lows). It is a bit more difficult to see on the chart, but Style and Country risk each saw double-digit declines (or close to it) at both horizons. At the same time, Industry risk was up more than 20%, and specific risk increased as well, so not all components fell.

We can also calculate a dense, asset-asset matrix to see the impact of changing stock volatility versus changes in correlations. Here we note that almost all of the decline has been driven by lower asset correlations, as we see a wide divergence in returns of Info Tech, up more than 17% over the period, versus Utilities, which fell more than 5%.

As sectors’ fortunes diverged, asset correlations fell to at least a six-year low, thereby driving risk down.