Short Squeeze or Sustainable Rebound?

This week's market rally has resulted in pundits pointing towards a recovery due to better-than-expected corporate earnings and a softening of the trade war between the US and China. In our conversations with clients, we're hearing a lot of speculation about whether or not this is a legitimate bounce in the market or simply a short squeeze in the wake of the broad selloff of the past several weeks.

As empirical skepticists, we focus on our observations of the underlying factor trends to see if we can achieve a better understanding of the current market environment. In the following analysis, we'll show why the Profitability factor might be signaling that we're seeing more of a short covering rally than a legitimate bounce.

Pulling the lens back briefly, our broad US market factor (99% correlated with the S&P 500) fell 10.4% from a 9/20 peak to 10/29 trough, and has since recovered about ~4% in the past few days.

We can see that we're currently in an oversold factor market on a normalized basis. None of the style factors are looking significantly overbought, while many more are flagged as oversold. Volatility and Market Sensitivity in particular are heading towards “Extremely Oversold” territory.

On October 11th, we discussed how the recent selloff had analogous elements to the so-called “Factormageddon” in early 2016. Today, we'll compare recent behavior of the Volatility, Market Sensitivity, and Profitability factors relative to their performance in 2016 to see if there are any relevant parallels. As a reminder, we view Volatility and Market Sensitivity as the primary arbiters of risk, while Profitability is a chief component of “Quality."

Volatility

2016: From 12/1/15 - 1/19/16, Volatility plunged 6.7% on a cumulative basis, then staged a brief rally before selling off further (-8.58% peak to trough). Around Jan 2016 the factor was flagged as oversold, hitting a nadir of -2 standard deviations below the mean on 2/11/16 before rallying ~4% into March.

12/1/15 - 3/10/16

2018: Volatility sold off -2.44% from 9/20 to 10/11, saw slight relief (+0.94%) into 10/16, and then fell again to -3.8% on 10/29 from the 9/20 peak.

9/20/18 - 11/1/18

Market Sensitivity

2016: Market Sensitivity similarly saw a double bottom, with the first coming on 1/19/16 (down -7.22% from 12/1/15). It then saw a brief uptick before selling off another 3+% until 2/11/16 (-9.28% peak to trough). The factor was also flagged as “Extremely Oversold” in early 2016, and then rallied almost 6% into March 2016.

12/1/15 - 3/10/16

2018: This factor was down -2.82% on a cumulative basis from 9/20 to 10/29, and has since popped up 1.17% as of yesterday.

9/20/18 - 11/1/18

Profitability

2016: Throughout the market turmoil during “Factormageddon,” Profitability mostly posted gains on a cumulative basis, up +3.73% from 12/1/15 - 3/10/16. Interestingly, from 2/8 - 2/16 the factor saw a slight downward move while Volatility and Market Sensitivity saw gains (likely short covering). The three factors then continued to post simultaneous positive returns, suggesting that investors were buying quality assets at the same time as short covering and putting risk-on bets. This simultaneous rally coincided with a real recovery in the market.

12/1/15 - 3/10/16

2018: While there was an initial rotation into profitability during the recent period of market volatility, the factor has sold off heavily at the same time that Volatility and Market Sensitivity have posted gains, falling -0.6% in the past two days alone. This is the contrary to what we observed during the 2016 recovery.

9/20/18 - 11/1/18

Conclusions

‍From a de-risking perspective, the recent market drawdown was shallower relative to 2016, as were the losses for Volatility and Market Sensitivity. Still, it's important to note that both of those factors hit a double bottom during that time, where there was an initial short cover rally from the perceived “bottom,” followed by another precipitous drop in returns for each factor.

In 2016, we saw Profitability consistently on the rise, eventually coinciding with the recovery in Volatility and Market Sensitivity. To us, this is indication that the large asset managers were back and investing in companies they liked at the same time that risk was back on the table. In the current market, we can see that since the initial (late Sep) rotation, Profitability hasn't come back into the market. This is a potential indication that a lot of this rebound is short covering and not “real” money coming back in.

Empirically, we do see room on the upside for these oversold factors, but in historical periods of similar de-risking, factors have sold off at much deeper levels (sometimes 2-3 standard deviations below the mean before coming back), so it's tough to tell if we're at the bottom yet.

Regards,
Omer