My colleague, Derivatives Strategist Brian Hughes, recently likened today’s market behavior to a duck: placid on the surface, but legs beating like crazy below. This metaphor highlights how the alpha experience of managers has been volatile, while the activity at the market level has looked quite muted by comparison. Our team, leveraging recent insights from Macro Strategist Juhi Dhawan, believes this is a symptom of a market that changes its mind frequently regarding what path the economy is actually on. Are we heading for a sustained recovery, or will the economy wilt once the US Federal Reserve (Fed) starts to taper its asset purchases? Should we be more focused on inflation upside risk or whether China’s struggles might lead to deflation? Is there additional fiscal stimulus on the way, or will the Delta variant get us first? There are seemingly countless “A or B” narratives.
The market has appeared to be more prone to these types of shifting narratives for the past four or five years. This has particularly been the case since the onset of COVID-19 in March 2020. The nature of this uncertainty means there may not be clear trades from the below insights. However, we hope they provide some historical context for the market we’re experiencing and some solace for investors who feel like certain strategies are running in place while the broad indices are slowly grinding higher. You are not imagining this dynamic. Today’s sustained period of oscillating narratives is highly unusual.
Quantifying today’s uncertainty
The depressed correlations at the sector level of the S&P 500 Index (currently in the bottom decile of observations over the past 20 years)1 show that sectors have been generally moving less in sync with one another on a daily basis. This suggests an environment where there is often substantial divergence between winners and losers. Periods of increased dispersion like this have been more frequent since 2016, though not as enduring as in the current regime.
Another way to capture this oscillation below the surface is by comparing factor volatility to overall market volatility. Figure 1 presents the ratio of the average one-month realized volatility for six primary market-neutral factor baskets (growth, value, momentum, size, quality, and beta) relative to that of the broad equity market (as measured by the Russell 3000 Index). This shows that on a daily basis, the dispersion in returns of factors like high versus low quality and large cap versus small cap is significantly exceeding that of the broader market. Although this signals a big opportunity set on a daily basis, no theme or narrative has trended sustainably, creating headaches for many managers. Notably, similar to the market’s depressed correlations, this trend toward increasing factor volatility relative to market volatility seems to have been building for a couple of years but has significantly intensified since March 2020.
Bottom line on US equity market volatility
The potential good news to take from this environment is that these conditions should not persist interminably. Many of these questions will ultimately be answered, with the path of the Delta variant and fiscal stimulus likely the most proximate. Importantly, however, we don’t expect to see the situation abate overnight — where all of a sudden a path is widely accepted, and the factor swings subside. Nevertheless, the amount of narrative churn should start to decline somewhat as the answers to these questions become clearer. Until then, it may be best to set your strategy and ride with it rather than try to respond to the ebbs and flows of the inflation versus deflation or reopening versus stay-at-home stories. Otherwise, today’s volatile narratives could leave you pummeled by the duck’s frantic paddling.
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1Sources: Bloomberg and Wellington Management. Based on average pairwise correlations of S&P 500 sector returns for one- and three-month rolling periods. Data as of 3 September 2021.