What's Driving Volatility & Beta?

In light of the substantial rally in the US market over the past week, we'll be refocusing our attention on our US model in order to see how the key Volatility and Market Sensitivity factors have behaved. We'll also attempt to identify what's been driving these factors by decomposing their underlying long and short components.

Let's start by taking a look at the past week's market and factor action:

‍US Market - 3/29/19 - 4/4/19

The S&P 500 enjoyed the longest win streak it had seen in 18 months — starting with last Friday's rally based on encouraging headlines on the China-US trade front, and keeping the momentum throughout the week. Friday, April 5th (not captured in above chart) saw more pop in the wake of a solid jobs report — beating on top-line growth and also indicating that wage gains had moderated.

Here's an update on how some key factors have changed in the US model over the past week, using our normalized return indicator:

• Profitability was the biggest winning factor on a normalized basis, as it continued to recover from the recent selloff and moved out of Oversold territory.
• Earnings Yield also saw a sizable normalized recovery, moving back towards Neutral from Oversold.
• Size also saw a fairly large move (+0.33 standard deviations), and has now crossed into Overbought terrain.
• Market Sensitivity and Volatility saw a move down on a normalized basis, but both saw positive performance on a cumulative basis.

What's Driving Volatility and Market Sensitivity?

‍Over the past week, the US model tells us that investors have been buying into Market Sensitivity and Volatility on a cumulative basis. What we want to better understand is whether these factors are being bought on the high end (i.e stocks that have high exposure to Volatility and Beta), or if low-Beta and low-Volatility stocks have underperformed.

As a reminder, we track factor movements through Factor Mimicking Portfolios (FMPs), which are constructed to isolate the exposure of a single factor within a given model. When we describe the returns of a specific factor, we're essentially looking at the weighted average returns of these long/short FMPs, because they are built to solely exhibit the characteristics of that factor. Thus, a 1% move for a factor in the market would equal a 1% move for the underlying FMP.

For each long and short leg that we highlight below, performance will be measured relative to the S&P 500 benchmark.

‍Volatility

‍Over the past week, Volatility saw positive return on a cumulative basis (+22bps). As an aside, please note that when we discuss the Volatility factor, we're describing the variance of stock movement after removing Market Sensitivity (Beta). In other words, the two factors are orthogonal to one another.

If we decompose the individual long / short components for this factor, we can see which leg has been driving performance.

There's no ambiguity here, with the short portion of the Volatility FMP down 2.25% and the long portion down 56 basis points. This is a clear indication that investors were selling names that had low exposure to Volatility over the rally of the past week, rather than actually bidding up names that had high exposure to Volatility.

‍Market Sensitivity

‍On a cumulative basis, Market Sensitivity (Beta) was up even more than Volatility over the past week (+0.99%).

Here's what that looked like when decomposing the long and short legs of the underlying FMP:

‍Market Sensitivity: Short Only (Active against S&P 500): 3/29/19 - 4/4/19 -1.86%

Here we can see that the short leg of the Market Sensitivity FMP saw significant underperformance, while the long leg also experienced some positive price action. This interplay suggests that investors went underweight low beta names, while also buying names with higher beta exposure.

Armed with this knowledge, we can conclude that the rally over the last week in the US market might not have represented a true return to risk-on trading, since investors weren't charging back into stocks with heightened exposure to Volatility and Market Sensitivity. Instead, we see that names with negative exposure to these factors sold off, which means we'll need to continue to monitor these portfolios before we can crown the movement of the past week as a sustainable bull market rally in the US.

Regards,
Omer