A note released yesterday by Barclays Capital (NYSE:BCS) continues the topic of quant liquidity disruptions, the upcoming major trend reversal and provides some disturbing observations.
The recent market rally that started on March 10th has been dramatic, unexpected, and actually quite painful for the vast majority of quantitative equity managers. Based on our conversations with numerous managers in recent weeks, we believe that most quantitative managers’ portfolios were not positioned in expectation of a rally. Of the nearly 80 managers we have talked to, only one manager said they were up since March 9th and the clear majority admitted to being notably down or stopped out on their positions. These managers were both long-only and long-short quant managers using market neutral and non-market neutral strategies, sector neutral and non-sector neutral strategies, longer term and intermediate term holding periods. It is fair to say that just about everyone is bewildered and trying to understand when this rally will end.
The key question given the dramatic performance on Thursday, is do we expect an impending reversal to happen shortly? How long do we think this current trend will continue?
In our note of April 2nd 2009, we wrote that we believed the general market rally and current trend in quant factors and themes was already over done and played out. At that point, we believed it had to end. In the prior run-up from January 7th through March 9th, the Sentiment Index was up +21%. Normally, in a reversal it loses approximately 60% to 70% of the value of the run up. As of April 1st, it was down -24%. As of the market open yesterday April 13, 2009, it was down -52%, thereby reversing over 240% of its run-up.
Normally, when we call for a trend to stop, we need to see three things. First, the trend has to have been strong and dramatic. Second, the trend has to have recently increased its trajectory in a hyperbolic way, to have accelerated its performance. And third, we need to have seen the trend reverse the clear majority of the prior trend.
On all three dimensions, we believe the current market conditions are clear and unambiguous. The current trend is strong and dramatic. We have clearly seen the trend accelerate, with the performance now coming from the tails of the distribution. And, we have reversed far more than the build-up of the prior trend. Think of a rubber band. What we are trying to identify is when the rubber band has been stretched far past its normal state. We believe unambiguously that we are at that point today.
All of this was true a week-and-a-half ago so we felt comfortable then calling for an end to the underperformance in Sentiment and the outperformance in Valuation. Today, we feel even more comfortable. And while on average, it takes 10 to 15 trading days after this condition has been met for the reversal to take hold, so we still have time, we certainly haven’t been proven right yet. As a prior boss repeatedly reminded me, and I humbly note here, there is no difference, though, between being early and being wrong.
If it is any consolation to analyst Matthew Rothman, you are not alone. Saying that the market has discovered an antigravity drive would be an understatement. However the outcome, based on Zero Hedge conversations, now may very well be comparable to the parabolic days of July 2007 which were followed by implosion of several large quants, and made even the previously unshakable Goldman Alpha to have a 30% down month. It may end up being poetic justice if history rhymes yet again.
Tomorrow: I discuss the ever increasing impact of quant strategies over the past 10 years, and how it can be mapped in real time.