CHG Markets Round Up Issue #9: Factor Rotations

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Much has been made of the recent outperformance of international stocks this year with some strategists calling this a regime change. We see the classic "alligator jaws" pattern when looking at the performance of the EFA versus the SPY this year and once again we see how narratives follow prices.

Thankfully, this is a trade that we are long and given this change in the market we need to update our understanding of the dynamics at play. First, our positioning:

As you can see, we are long foreign stocks and short US stocks, namely momentum and quality names. The quality positioning is not intentional, so I looked at QUAL's holdings and Nvidia is in the top 10 so that makes sense as we don't own anything that looks like this portfolio.

We were eyeing up META back in 2022 but never pulled the trigger unfortunately. NVDA is obviously also a momentum name, as well as NFLX and META, so there is a decent amount of overlap here between our short factor exposure. All the long-term charts for these names look the same: a breakout from the 2022 range, a recent excess high, and a big red candle. Support doesn't come into play until we get back to the 2022 or 2023 highs so there isn't a rush in any of these names or the broader market.

If we look at EFA individually, the chart is not all that inspiring, especially as it approaches a high-risk area.

Realizing that the EFA has yet to eclipse its 2007 high we are reminded of the degree of underperformance versus the SPY since the GFC. As the EFA nears the 2007 high risk grows, and if it can find acceptance above that high it has a lot of upside potential. However, the EFA portfolio is a very broad representation, and we can see that certain markets, namely Europe and Japan have already broken out higher.

It's also surprising that the EFA is only back to where it was in September, which makes us realize that the difference this time is that it has decoupled from US stocks. It's not just outperforming within a trend higher; it is rallying while the SPY is selling off. Looking at the rolling correlations we can see the extent to which it has decoupled and, we see that this decoupling has been in play for a while now, picking up steam in September.

What we realize here is that our performance has been primarily driven by a short correlation position between US stocks and foreign stocks. It's notable that this plunge in realized correlation only had a small reversal around the US election and quickly resumed its decline despite US stocks not turning lower until last month.

It's also interesting that all these foreign stock charts resemble the Value factor chart. Value has held up despite the broader pullback in US stocks.

Indeed, we see a similar "alligator jaws" pattern when we look at growth versus value this year.

Zooming out we can see the same long-term reversal potential that we are seeing in foreign stocks. In other words, long-term trends are being seriously challenged recently. We saw the Value factor outperform during 2022, but foreign stocks actually underperformed during that period, so again, what we are seeing today is new.

?Every time growth stocks experience a pullback these growth versus value charts pop up and value investors start to fantasize about huge rotation out of growth and into value like we saw after the popping of the internet bubble. Likewise, we have all the chatter today about foreign stocks embarking on a new secular trend of outperformance.

Looking at shorter term correlations we see that recently the EFA correlation has moved back up, while bonds and commodities are moving in opposite directions, and stocks and commodities are moving more closely together. The story we see here is one of the market pricing in a slowdown in growth as bonds start moving higher as stocks and commodities move more closely together. Notably, the stock-bond correlation is hovering around zero and has been moving higher recently.

If we look down the EFA column (2nd column) we see that the only negative correlations are against bonds (TLT). If we look at the upper triangle, we see that that correlation has gotten more negative over the last 90 days. There is a contradiction here: the SPY, TLT, and EFA are moving more closely together but the EFA and TLT are moving apart. This places added importance on bonds today and increases their attractiveness as a portfolio diversifier which is what you would expect during a growth slowdown. Also, we see that of all the factors, EFA is most highly correlated to QUAL, which we are short so that provides a nice offset.

Earlier last year, when the EFA was decoupling from the SPY, its correlation with TLT was increasing so we can see a dynamic here where the foreign stock story was leading but now the US growth slowdown story is starting to take the reins. It makes sense that a US slowdown would drag foreign stock markets lower as well. All else being equal, if the US slowdown story loses steam, we should expect the foreign stock leadership to resume. However, after having tested US growth prospects and passing the test we would expect the bonds to come under pressure which would create a headwind for foreign stocks and the more durable prospects for the US could further impair foreign stock leadership.

We can easily get ahead of ourselves here, but it is useful to see the underlying dynamics driving the market. The wild card in all this is the Fed. Currently the market is only expecting about three cuts this year. Lower rates have been supportive of stocks in the past, just as higher rates put pressure on stocks in 2022. However, the manner in which rate cuts come will be important, if the Fed is viewed as ahead of the curve, they will be supportive of risk assets but if they are viewed as behind the curve, they will not be supportive of risk assets, and we'd expect to see a further recoupling of EFA and SPY. The stock-bond correlation will show what the market is thinking on the Fed being behind or ahead of the curve; a rising correlation would mean behind the curve and a falling correlation would mean ahead of the curve.

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