What (didn’t) happen in the February sell-off
March 15, 2018
From January 26 to February 8, the S&P 500 sold off by 9%. The sell-off was driven by systematic risk-targeting strategies that responded to a rise in equity volatility. As these strategies are invested in futures, they sold off the whole index, which explains the low dispersion of sector returns during this period.
Another way of viewing this is in factor performance; in a correction, high dividend-yielding stocks and quality normally outperform. This was clearly not the case.
As important, only the volatility of stocks increased materially and not that of other asset classes, such as rates or currencies. This is why we only saw a decline in equities.
Therefore, safe haven assets such as Treasuries, gold or the Swiss franc did not respond in a “risk-off” manner.
Subsequent to the correction, the market rallied by 5% (a 99th percentile one-week move vs. S&P 500 trading history), led by the two most crowded sectors in the S&P 500 (financials and technology).
Through the lens of factors, we can see that the momentum factor, which barely registered the sell-off, rose subsequently. In contrast, the value factor fell before, during and after the sell-off.
The sell-off was technical in nature
It was driven by systematic strategies being forced to de-risk in the face of rising volatility. This was not a true flight to safety or a real correction. Investors, conditioned to buy the dip, continued to do so into the crowded longs of tech/FANG and banks. As such, our portfolio did not add as much value as we would have anticipated during a period of negative market returns.
In a true correction, we expect our defensive positioning to pay off in a much more meaningful way. In fact, the case for defensive sectors has only strengthened. The multiple of the S&P 500 has contracted somewhat, but this has not been uniform. Since December 1 (we chose December to be fair and incorporate the pricing of tax cuts), the market multiple has declined by 1.4x. However, this was led by defensive sectors, while sectors such as IT maintained their multiple and the internet industry saw an increase.
All in all, the market remains close to the most expensive it has ever been, even with bullish EPS growth estimates.
The rise in volatility was too short to shake investors’ perception of invincibility. As investors are massively overweight momentum and growth stocks, they did not see the sell-off in the same way, and, in fact, many will have added alpha, as popular longs outperformed popular shorts (as defined by Goldman Sachs; see graph below).
As such, our valuation and sentiment vectors did not move materially for the United States, and we continue to have conviction that the US market is set for a correction in the coming months.
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