A Blog by Jonathan Low


Jun 16, 2017

Why the US Stock Market Is Looking Like 1999, Even Though It Now Belongs To Bots

Despite the advent of powerful technologies, a small group of investors is chasing a small group of stocks. JL

Dani Burger reports in Bloomberg and Ryan Vlastelica reports in Market Watch:

Passive and quantitative investors now account for about 60% of all equity assets, compared with 30% a decade ago, according to data from JP Morgan Chase & Co. The firm estimates that only 10% of trading volume now comes from discretionary investors. (In) 1999 it was the ‘Four Horsemen of the Nasdaq’ leading the market; today it’s the FANG - Facebook, Amazon, Netflix and Google (the parent company of which is Alphabet. Apple Inc is at times included in this group. Market metrics are mirroring 1999, shortly before dot-com bubble burst
Bloomberg - That money you see sloshing around in the U.S. stock market? It belongs to the robots.
At least, that’s the picture emerging from a growing divergence between quantitative funds and discretionary managers. Systematic strategies have barely budged from near-record participation in U.S. stocks. Meanwhile, fundamental equity long-short managers can’t afford to be anything but picky, considering the market’s narrow leadership.
The result: the largest gap on record between humans’ and computers’ gross exposure to U.S. equities, data compiled by Credit Suisse Group AG show. For now, systematic traders are the dominating force in markets.
“This is the largest footprint for quants. It’s a function of allocation and leverage,” Mark Connors, global head of risk advisory at Credit Suisse Group, said. “The reason why that’s important is that they’re not going away. Complexity isn’t going to be rolled back.”
In a sense, the divergence reflects the growing popularity of quant methods over traditional strategies. Nailing down the exact size of the quantitative space is nearly impossible, though some estimates are as high as $500 billion. What’s more certain is that it’s getting bigger. Quant is the fastest growing category on both Credit Suisse’s prime brokerage platform and the broader universe.
Passive and quantitative investors now account for about 60 percent of all equity assets, compared with 30 percent a decade ago, according to data from JP Morgan Chase & Co. The firm estimates that only 10 percent of trading volume now comes from discretionary investors.
But determining whether this computer-driven force dictates market moves is another matter. Quants on the Credit Suisse platform are roughly defined as funds that invest in thousands of equities and trade dynamics, rather than making stock-specific bets. Since they use different signals and time horizons, their combined impact is likely muted.

Finger Pointing

“Diversity of market participant trading is a very important element of a healthy market. Quant funds certainly add to that diversity, and I feel that is very good,” said Jaffray Woodriff, co-founder and chief executive officer of Quantitative Investment Management, which oversees $3.5 billion. “Funds that are completely uncorrelated to everybody else and that also trade a lot of volume are very good for the liquidity of the investment ecosystem.”
That hasn’t stopped some from pointing fingers.
Through Monday, the Nasdaq 100 Index had its worst two-day slide in nine months. Yet the strongest indicator of whether a stock in the gauge tumbled was not its industry, but momentum -- or the strength of a share’s gains over the past year. That kind of proportionality is the hallmark of a systematic strategy that unwound momentum positions, said Andrew Lapthorne, global head of quantitative strategy at the bank.
Regardless of quantitative investors’ behavior, fundamental managers are ceding whatever control they have left. Gross exposure to U.S. stocks among equity long-
short funds, the largest category of discretionary investing, has dwindled in 2017 to near a record low. The closing out of short positions that burned managers is partially to blame for that, according to Connors.

Increasing Leverage

Over the past three months, the most shorted equities have outperformed hedge fund favorites by nearly 7 percentage points, according to baskets compiled by Goldman Sachs Group Inc. Meanwhile, narrow leadership has made it difficult to hold bullish positions on a variety of industries.
“You can’t get bigger if half of your book isn’t performing,” Connors said. “They’ve had to be long tech because that’s all that’s worked.”
Then, there are the quants, who hit the highest gross exposure to equities on record around May 12, data from Credit Suisse show. It’s since come down slightly, but still remains
elevated. As volatility in the stock market stays low, returns among quantitative strategies have been compressed, likely compelling managers to increase their leverage to juice up returns, Connors said.
Likewise, Quantitative Investment Management’s Tactical Aggressive Fund, a $1.2 billion equity fund, has higher than average gross exposure, according to Woodriff, who cited the low volatility and high dispersion environment. That’s paid off, as his fund rose 13 percent in May to round out a 55 percent gain for the first five months of the year, according to an investor document seen by Bloomberg News.
Even so, quants’ exposure tends to be more steady than fundamental managers, said Maria Vassalou, head of Perella Weinberg Partners LP’s Global Macro Fund.
“Discretionary managers come and go, and can affect the volatility of the market more. When they take risks, they sometimes bet the farm,” Vassalou said. “Quants focus on a lot of assets that make up their portfolio. They’re less likely to be impactful overall for any particular stock.”

Market Watch - Investors who have been in the markets for at least 20 years can be forgiven if they’ve been feeling an unsettling sense of déjà vu lately.
The recent selloff in technology shares on Wall Street—which began abruptly last week, although the sector is still the best-performing industry of 2017 at current levels—has drawn comparisons to the abrupt end of the original dot-com run-up, and not simply because it’s the same sector driving market direction, and because the same sector is facing the same charges of being overvalued.

“This is my 33rd year in capital markets, and what I’m seeing is very reminiscent of 1999,” said Mark Travis, chief executive officer of Intrepid Capital Funds. “Back then, it was the ‘Four Horsemen of the Nasdaq’ leading the market; today it’s theFANG.
FANG refers to four internet names—Facebook FB, +0.08% , Amazon AMZN, +3.30% , Netflix NFLX, -0.15% and Google (the parent company of which is Alphabet GOOGL, -0.89% )—that have fueled the market’s advance this year. Apple Inc AAPL, -0.41% is at times included in this group, as well. All are among the biggest companies in the U.S. by market capitalization, and all have seen gains of more than 20% this year. The four have an average price-to-earnings ratio of 125.59, although that is mostly due to Netflix (which has a P/E of 287.91) and Amazon (at 153.03). The price-to-earnings ratio of the S&P 500 SPX, -0.22% is around 18.4, according to FactSet.
“You can’t justify paying these prices for these businesses. Investors are just chasing momentum,” Travis said, citing the recent initial public offering of Snap Inc. SNAP, +0.62% as an “egregious” example of overvaluation. “They’d have to double revenue just to break even,” he said of the social-media company.
Other market metrics are eerily mirroring what happened in 1999, shortly before dot-com bubble burst and sparked a broad-based selloff, one so severe for tech that the sector only fully recovered earlier this year. The resemblance in conditions means that “from a big-picture perspective, the comparison to 1999 holds up remarkably well,” said Brad McMillan, chief investment officer at Commonwealth Financial Network. “1999 and 2017 do indeed bear more than a passing resemblance.”
He added that “1999 was a good year, just as 2017 is shaping up to be a good year. With the wisdom of hindsight, though, we know that even as things were great, the seeds of the next downturn were already growing.”
McMillan looked at the four economic indicators he deems most important for comparing market conditions across eras: consumer confidence, business confidence, jobs growth and the yield curve. All of them reflect trends that are today equal to or are even more extended than in that earlier era.Of McMillan’s four indicators, perhaps the least troubling one is consumer confidence, which he said was “very high right now,” though “not as high as it was in 1999, to be sure.” “The path up looks similar. After several years of positive developments, people are feeling good, and they’re ready to act on it,” McMillan said.
Business confidence, as measured by the Institute for Supply Management’s read on manufacturing, “is even higher now than it was in 1999,” a possible sign of a top.
As to the metric that McMillan said was the “most important,” job growth “has closely tracked levels of the 1990s over the past several years. We did not get the early bump to quite the same degree, but the current growth pattern—and the slow decline in growth—looks much like the late 1990s.”
The most recent payroll report showed a slowing in the number of jobs added.


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