FAST FIVE: Is This The Start Of The Factor Crash That Morgan Stanley Has Been Warning About
There is just one problem: while Kolanovic may finally be right, a recent note from Morgan Stanley's Chris Metli suggests that any reversal out of the popular growth/momentum/low-vol factors and into value would hardly be a walk in the park and will be met with a very violent market reaction, one which could be far greater than the September quant crash, to wit: there is a concerning shift in the relative volatilities of factors. For all of 2019, Growth names became steadily less volatile than Value names – but this is now showing signs of reversal. Any increase in volatility in Growth is concerning because there is a greater overlap with the long side of investor portfolios (while Value is more representative of the shorts), and higher volatility on the long side of books is more dangerous because it impacts a broader investor base (note the Oct/Nov 2018 unwind had higher Growth volatility).
It is also worth noting that any factor unwind would happen in a time of record high hedge fund gross leverage.
For those who missed Metli's note previously, here it is again: * * * Authored by Christopher Metli, Executive Director of Morgan Stanley Quant Derivative Strategies Investors largely shrugged off the factor rotation on Feb 4th as an isolated event, but it shouldn't be dismissed – higher factor volatility is structural and is here to stay. Funds are taking bigger factor bets, positioning is crowded, leverage is high, and factor correlations are getting more unstable – all of which mean that future rotations will occur again (probably soon), and will likely be violent. While fully acknowledging that Fed liquidity is supportive of Growth stocks, it's also true that the consensus believes the rally in Growth will continue. As a result QDS thinks the bar is low for an unwind should the economy change in either direction – a growth scare is the worst outcome for most investors, but growth acceleration can be painful too.
stock replace, keeping upside but limiting downside) Hedging against sharp moves lower in the most vulnerable areas of the market – Crowded stocks (MSXXCRWD) or Growth vs Value (MSZZGRVL) First, investors should recognize that the sources of risk have been shifting over the last 10 years. Factor volatility has been on a steady upward path since 2010. This impacts everyone (not just quants) because how stocks rank on factor scores now account for an increased portion of the total dispersion in the market.
Trading Implications Fundamental traders with concentrated portfolios should consider replacing stretched longs with call options, retaining the upside but minimizing downside risks. The below screen shows top 100 S&P 500 stocks that are within 2% of recent highs – the upper left is where volatility is low and upside skew is steep. For example names like ADP, CRM, and CHTR in the highlighted box below have call options that price relatively attractively versus history.