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Market Rally Met With Narrowing Leadership
Active, bottom-up oriented investors can be caught flat-footed by unforeseen bouts of volatility—indeed, 2020 has already seen several unprecedented selloffs and remarkable recoveries. However, a bottom-up approach needn’t preclude using tools to help identify and, to the extent possible, mitigate the portfolio risks associated with meaningful market reversals. Admittedly, market unwinds will likely never be entirely foreseeable. But we believe it is possible to anticipate periods where the risk of a market reversal is high—and as active managers, to then reevaluate the risk-return tradeoff for portfolio holdings with material unwind risk.
One tool we use to try to help us identify such periods is market breadth, for which we’ve developed an indicator that measures the percent of variance explained by one or two of a set of market-neutral factors—including momentum, value, anti-beta, quality and size. A low breadth indicator reading suggests market risks are diversified and the market is less vulnerable to a shock; conversely, a high reading suggests the risks are more concentrated and the market may be more susceptible to heightened volatility following some exogenous shock. Currently, our breadth indicator is making multi-year highs—i.e., the market is narrowing (Exhibit 1).
Exhibit 1: Market Breadth Indicator
High breadth indicator readings are often caused by the persistent outperformance of one or two factors that have become crowded and are therefore increasingly vulnerable to an unwind. For example, the breadth indicator was similarly elevated in late 2015, several months before a growth/momentum unwind caught many active managers off-guard.
The question in the face of a high reading is which factor is driving that reading. To help parse that, we use our sigma charts, which fit a linear regression to the long-term trend of a given market factor and help us see when that factor is approaching the upper or lower two-standard deviation bands—a statistically rare event. A factor’s breaching of either band would suggest elevated reversal risks and would generally suggest that factor may be contributing to narrowing breadth.
Our current sigma charts show the growth factor seems at elevated risk of an unwind. In fact, as of September 15, 2020, the growth factor sits nearly 4.5 standard deviations above the historical trendline, suggesting growth’s outperformance versus value has reached an extreme (Exhibit 2).
Exhibit 2: Growth Factor
Another current driver of narrow breadth is the concentration of capital in the S&P 500® Index. The index’s top-five stocks are Apple, Microsoft, Amazon.com, Alphabet and Facebook, which collectively account for nearly a quarter of the index’s total market cap—a level of concentration that exceeds the dot-com bubble’s peak (Exhibit 3).
Exhibit 3: Top 5 Stocks as a % of Total S&P 500 Market Cap
This combination of readings leads us to believe growth stocks’ ex-ante risk-adjusted returns appear skewed to the downside. While we cannot forecast with any precision when an unwind might occur, we believe it is important to attempt to identify such possibilities and take what steps are available to mitigate portfolio holdings’ potential exposure. For example, we address these risks in our portfolio by first estimating the sensitivity of our holdings to these risks. Then, we reassess the estimated risk-reward by blending both our fundamental and thematic views with the potential impact of a factor unwind. Our goal is—where supported by our fundamental, bottom-up work—steering our portfolio away from potentially crowded factors. We believe this approach helps us mitigate risks while preserving expected upside.
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