- Low Volatility, Low Volume and High Concentration: Triple Treat or Triple Threat?
- Factor Performance: Some sharp reversals from Q1, and not in the “right” direction
Market volatility has continued to decline as stocks have recovered from their March lows. In fact, recent volatility readings for the STOXX® USA 900 are lower than they have been since January 2022 – right before the war in Ukraine ignited. This may seem like good news for investors, who now have less concern that money invested today will suddenly be worth less tomorrow, but it may also mask some underlying dynamics that are less favorable. For one, the spread between the short-horizon statistical and fundamental forecasts in the US is now more than three percentage points, the highest it has been in at least 10 years. This suggests the statistical model “sees” a risk not currently captured by the factors in the fundamental model. Note that we only see this positive spread in the US; in other markets the spread is close to zero or slightly negative.
Over the past six months or so, we have commented often in these notes about the low level of trading volume. It ticked back up in March as banking concerns drove investors away from financial stocks, but as concerns abated, volume dropped back down and ended last week well below the level of the same period a year ago. We believe low volume suggests a lack of conviction in the promise of a bull market, that investors don’t know what to do until they get more clarity, so they are not doing much of anything, and/or that money has moved out of stocks as higher yields make bonds a more-attractive alternative.
…and High Concentration
In last week’s notes we discussed the concentration in US market returns, especially in March and early April. When only 30 or 40% of names in the index actually drive the index return, it means the likelihood of a typical manager of outpacing the market is lower and enhances our view that there may be a lack of overall conviction of equity investors. While the percent of stocks beating the benchmark ticked just above 50 last week, outperformance may remain elusive. Quarter to date, the percent of stocks beating the market is also under 50%.
As market volatility has fallen so has dispersion (the standard deviation of five-day returns), which hit its lowest level since December 2021 in late April, but has remained low since then. As in a highly concentrated market, a low dispersion market means that it is tougher to beat the market, because the reward to being “right” on an individual asset selection is lower than average.
Overall, these charts serve to reiterate the warning we made last week: While markets may be going up, they are being driven by few stocks and on low volume, making it a tough market to beat and suggesting the recovery is fragile. In addition, the higher volatility forecast from the statistical model suggests there may be a hidden risk that we are not accounting for.
See graphs from the United States Equity Risk Monitor of 5 May 2023:
The following chart is not available in the Equity Risk Monitors but can be furnished upon request:
Factor Performance: Some sharp reversals from Q1, and not in the “right” direction
Several factors are struggling so far in the second quarter (that is, producing returns in the opposite direction to long-term expectations), both within the US and outside its borders. Some are seeing a reversal from Q1, when returns were better. Others suffered in the first quarter but are faring as expected in the current quarter.
In the US, both Value (which fared well in Q1) and Earnings Yield (which did not) have produced negative returns since the beginning of April. And Profitability saw a sharp reversal of fortune this quarter. Both Market Sensitivity and Medium-Term Momentum shifted gears from their Q1 performance, but so far in Q2 are behaving as expected.
Outside the US, factor returns look different from Q1 as well as versus the US. Both Profitability and Medium-Term Momentum continue to disappoint, with negative returns in both periods. As the dollar has weakened, Exchange Rate Sensitivity’s return turned from negative to positive (i.e., it is better to be exposed to a company’s home currency). Value’s return was positive in both periods, whereas Earnings Yield is producing negative returns so far this quarter after a good Q1.
Even where returns have been disappointing so far this quarter they have generally not been too outsized relative to volatility expectations. Still, factor return expectations are based not only on long-term results, but also assume “rational behavior” on the part of investors. When factors “misbehave” it may signal a retreat from that rationality, although when that happens the magnitude of returns is usually much higher. So, some of these returns and reversals are mildly concerning.
The following charts are not available in the Equity Risk Monitors but will be furnished upon request: