It must be a pretty dull week in the stock market if everyone is talking about factors.
Stock groups with different characteristics—so-called factors—had been running in very different directions over the past few months. The market’s best performers, known as high-momentum stocks, and the least volatile, known as low-vol stocks, had outperformed as investors shunned the cheapest, smaller, more-volatile ones. In July, the performance gap between the two sides was wider than at any point in market history, according to J.P. Morgan data, even surpassing the spread during the tech bubble in the late 1990s.
Now that trend has sharply reversed. From Sept. 5 to Sept. 10, the MSCI USA Momentum Index dropped 3.1% and the S&P 500 Low Volatility index fell by 1.1%, even as the broader S&P 500 remained largely flat.
Value and small-capitalization stocks, meanwhile, have sprung to life. The Russell 1000 Value Index gained 1.6%, while small-cap Russell 2000 jumped 2.1%—even as the Russell 1000 Growth index declined 1.4% and the large-cap Russell 1000 rose by only 0.1%.
Don’t be surprised if this rotation remains in place until at least October—and perhaps even longer than that.
What was behind the sudden shift? Before last week, investors appeared to be betting that bond yields would fall. And for a while, that trade worked. Both momentum and low-volatility baskets are loaded with defensive stocks that tend to rise as yields fall—a signal that bond investors are losing faith in the economy.
No longer. The 10-year Treasury yield rose from 1.461% on Sept. 3 to 1.733% on Sept. 10, while the yield curve, which had been inverted, steepened. “The extreme factor moves we are seeing in the equity market are driven by activity in the fixed-income market,” Nomura Instinet strategist Joseph Mezrich wrote on Tuesday.
There’s a good reason for that. As investors turned more defensive this year, low-volatility stocks have attracted significant assets across both retail and institutional platforms. And that has made them expensive. Christopher Harvey at Wells Fargo now recommends that investors reduce their exposure to low-volatility stocks, a stark contrast to his position at the beginning of the year.
“About a year ago, we talked about low-vol strategies being one of the most unloved and underappreciated strategies in the marketplace,” wrote Harvey on Tuesday. “However, the style is no longer the technically oversold and underowned strategy it was in years past.”
As we’ve noted, the momentum basket, has recently shifted from being a group of fast-growing companies to include many of the market’s least-volatile stocks. Those are also the ones most dependent on yields going down, explains Bernstein analyst Sarah McCarthy.
“The market was paying for continuity of the current macro trend, rather than paying for growth characteristics of stocks,” she wrote. “The move upward in yields over the past few days seems to have triggered this factor rotation.”
The question now: Does the reversal have staying power? To answer it, we need to consider what could cause investors to again prioritize safety over all else.
For J.P. Morgan strategist Marko Kolanovic, that would be a failure of the trade discussions between the U.S. and China scheduled for October. If the negotiations fail, the recent moves could well be unwound. If progress is made, however, it will buy the market more time for the global monetary and fiscal stimulus to take effect—and for the rebound to continue. Before that, there is now a window of at least three weeks for bond yields to continue to rise and for stocks to move higher, especially after President Trump delayed a rise in tariffs to mid-October.
One way to play the current rotation in factors is to buy the small-cap companies in the energy and materials sectors, Kolanovic says. The group has been hit particularly hard since it was at the nexus of selling by low-volatility, growth, and momentum investors. “Normalization of these extreme conditions, and related feedback loops, may create unusually high upside in this market segment,” wrote Kolanovic in a Tuesday note.
At least until the next rotation.