Tag Archive: style

Recent rally in “junk stocks” is not unusual

Financial headlines have been captivated recently by explosive behavior in certain “meme stocks” that have been the subject of intense speculation by online retail traders as well as some hedge funds. This has been accompanied by a general trend of outperformance by smaller, money-losing, heavily-shorted, and volatile stocks (sometimes referred to as “junk stocks”, similar to risky high-yield “junk bonds”).

Other signs of “froth” include aggressive use of SPACs (Special Purpose Acquisition Company, or “blank check” company that raises money to acquire private companies), historically high trading volumes and activity in short-term call options, and growing margin debt.

This has raised broader questions about why “junk stocks” seem to be rallying much more than “quality stocks” and whether this is historically unusual.

The short answer is: no, this is not historically unusual under these circumstances. The specifics vary, but similar patterns have been seen in the past when markets are recovering from a sharp decline and policy support is very aggressive.

The first chart below plots the recent (past year) returns of the Dow Jones Thematic Market-Neutral Style indices. These are hypothetical long-short indices (i.e., assuming equal dollars invested in offsetting long and short portfolios) based on widely-used factors, using the 1000 largest US stocks, and constructed sector-neutral.

The key points are:

  • Quality and Anti-Beta (low beta) are highly correlated, since quality stocks (defined by Dow Jones as those with high Return on Equity and low Debt/Equity ratios) also tend to be lower beta. Size (small-caps) is often negatively correlated with Quality and Anti-Beta (since small-caps are generally lower quality and higher beta). Risk is the key theme connecting these factors.
  • November 6th (where shaded area begins) is when Pfizer announced its first COVID-19 vaccine results.  This marked the point at which the recent themes really began: outperformance by low-quality, high-beta, small-cap stocks. This initially hurt the price momentum factor since those had not been the leadership areas previously.
  • The Value factor had a bounce in November, but since then has shown no net performance. Thus it is not Value that has been rewarded, but risk, in the period since November 6th.
  • It is also not coincidental that early November was when the US election occurred, and the results (fully decided in January) increased the perceived odds of additional aggressive fiscal stimulus. Such stimulus tends to benefit smaller, weaker (riskier) companies that had been hit hardest by COVID-19.
  • Thus riskier companies have had recent tailwinds from both COVID-19 developments and greater fiscal support.

Dow Jones Thematic Style Indices All

The long-term chart below shows the Quality and Anti-Beta factors since the data begin in 2001. We can see the correlation is clear over the longer-term, including the most recent few months.

Dow Jones Thematic Style Indices Quality AntiBeta

The key point here is that in each of the previous periods of post-recessionary aggressive stimulus (2002-03, 2009-13), higher risk (lower quality) stocks were rewarded as investors sought the biggest “bang for the buck” from the stimulus and recovery. Weaker, riskier stocks tend to get the most benefit from policy support, while stable, higher quality companies do not need it and get relatively less benefit. Thus the current conditions are not unusual, and fully consistent with a risk-on environment, in line with our other indicators that remain bullish for equities on a tactical basis.

Vaccine news brought record style rotation in stocks

The headlines on Monday (Nov. 9th, 2020) from Pfizer announcing favorable early results in their COVID-19 vaccine trials, while certainly welcome, clearly caught investors off guard. While the major indices were either up or flat on the day, there was a historic level of divergence within the market among the various styles and sectors.

Such extreme rotations remind us that there is risk in the equity markets even when stocks overall do not fall. Investors focused on relative performance likely either had a huge win or huge loss on Monday.

The charts below give some perspective. We highlight returns to widely-used market-neutral factors (styles) that were most impacted yesterday: price momentum, value, and size (small-caps).

The first chart below shows how extreme the returns on Monday were in historical context. We use the daily returns of the Dow Jones Thematic Market Neutral indices for the three styles, data for which goes back to 2002. These indices assume equal dollar amounts invested in long and short portfolios (netting out to zero, or “market neutral”) based on the standard textbook definitions of price momentum (which favors stocks that have outperformed over the last 12 months), value (which favors stocks that have low multiples of price to book value, earnings and cash flow), and size (which favors stocks with lower market capitalizations). The indices are rebalanced quarterly.

Dow Jones Thematic Style Indices Daily Returns

The market-neutral Momentum style had the biggest move on Monday among these indices: a daily return of -14%, the largest daily movement (up or down) in the history since 2002. The next most negative day (April 9, 2009) was a -7% return, so Monday was twice the magnitude of the next-worst day. The biggest positive return historically (April 20, 2009) was +10%. The normal range for daily returns since 2002 (where 95% of observations have fallen) has been -1.3% to +1.3%. So Monday’s Momentum return was extraordinarily extreme.

The Value style was one of the big winners, showing a market-neutral return of +8% for the day on Monday. Before this week, the Value factor’s biggest gain was earlier this year (May 26th) at 4.4%, so Monday’s return was almost twice the next-largest move (the biggest decline was similar at -4.3%). The normal range for daily returns for Value since 2002 has been -0.9% to +0.9%.

The Size style also had a big day, showing a +4.5% return, meaning small-cap stocks outperforming large-cap stocks by nearly 5%. This basically matches the previous maximum return of +4.7% from March of this year. The Size factor has had a similar typical daily range as Value (+/- 0.8%).

However, context is important here. These extreme moves in styles essentially constitute reversals of the general trend they’ve shown most of this year. Momentum had been one of the stronger styles until this week, while Value and Size had been performing poorly. The second chart below shows the indices themselves (rather than daily changes) over the last 12 months.

Dow Jones Thematic Style Indices

We see that market-neutral price Momentum had posted a return of +36% over the 12 months through November 6th, so Monday’s drop cuts into that gain but still leaves the strategy with a positive return for the last 12 months.

Value, by contrast, had been the reverse: it had shown a -37% return (market neutral) through November 6th, so Monday’s gain helped but leaves the style still significantly negative over the last 12 months.

Size (small-caps) had also underperformed coming into this week, showing a -16% return through November 6th. Thus the 4.5% gain reduces the 12-month loss, but still leaves small-caps lagging large-caps by a wide margin over the last year.

The question remains open as to whether Monday’s sharp reversals in relative performance within the major equity market styles (and related sectors) mark the beginning of a durable new trend, or a short-term positioning event that will reverse like a similar event in May/June of this year. Further developments in COVID-19 vaccines, fiscal stimulus plans, and corporate earnings will likely help answer that question, but the uncertainty surrounding these developments means that elevated internal volatility and rotation in stocks may well continue in the coming months.

Growth leadership easing as rotation increases

One of the most notable market trends in recent weeks has been the corrective action in the formerly high-flying US large-cap Growth stocks. The dominant Tech-oriented companies that have been responsible for much of the gains in US large-cap indices for several months finally saw some significant selling pressure in the first two weeks of September.

The first chart below shows absolute and relative returns for the S&P 500 Pure Growth and Pure Value indices (i.e., the style indices restricted to stocks that fall entirely into their indicated style, leaving out those with weight in both indices).

SP500 Pure Growth Value Indices

Key points:

  • The Growth index has been above its 50-day moving average since mid-April (and made new highs recently), but has now returned to that average after its recent correction. Any further declines could raise worries about an intermediate trend change.
  • The Value index has failed to even approach its January highs and has made little net progress since early June. It is also sitting near its 50-day average.
  • Growth/Value relative returns show little net change in the last two months, following a period of drastic Growth outperformance. This is consistent with our recent sector allocation recommendations to clients that have reduced style-level sector bets in favor of intra-style differences.

Corroborating the Growth/Value trends is the relative performance of the Growth-heavy Technology sector’s returns. Below is a chart showing our broad (300+ constituents), equal-weighted US Technology sector performance relative to the broad (2000+ constituents) US aggregate.  


We can see that after a period of sustained outperformance through the middle of this year, the relative returns for Tech have been much more mixed, and have dipped lately. Investor optimism toward Technology has shown signs of reaching extremes recently, and thus some corrective action is not surprising.

We continue to expect Technology to be a leading sector on an intermediate-term time frame, but both the sector and the overall market may have to go through further choppy trading activity and rotation near-term.