Not your father’s market: Tech tantrum shows how US equities trading has changed

US technology stocks are now enjoying a welcome bounce. But the savage two-day “tech tantrum” that wiped billions off the market capitalisation of firms like Apple and Amazon has raised a host of interesting questions about the dramatic evolution of the US stock market and the investment industry in recent years.

Explanations for the sudden sell-off abound, but many analysts are pointing to the increasingly algorithmic nature of investing. JPMorgan estimates that only roughly 10 per cent of US equity trading is now by traditional, “discretionary” traders, as opposed to systematic, rules-based ones, like exchange-traded funds, advisers who make rules-based ETF investments and computer-driven hedge funds.

Despite the rebound, many investors and analysts remain edgy, nervous that the sell-off could resume. Fund managers surveyed by Bank of America have fingered tech stocks as the most crowded trade in markets for a second month running, and Citi analysts warned that there “is a real danger that this will be followed by renewed losses” in the coming weeks that could end up in a double-digit percentage correction.

“This set up is now making us very cautious in the near term on the equity markets for the first time this year,” the US bank’s analysts wrote to clients on Tuesday.

What happened?

On Friday afternoon, a host of technology stocks that had been on a tear for much of 2017 suddenly and mysteriously tumbled.

Nvidia, a fast-growing chip company, went from a gain of over 5 per cent early on Friday to end the day down 6.5 per cent – an unusually violent swing for a $90bn company on no news. The tech industry’s giants were also pummelled, with the so-called FAANG stocks – Facebook, Amazon, Apple, Netflix and Google – shedding over $100bn of market capitalisation on Friday.

The weekend proved little respite. The S&P 500 technology index fell another 0.8 per cent on Monday, before clawing back some of the losses on Tuesday.

What was the trigger?

No obvious fundamental cause has been found, but analysts and investors have pointed to a confluence of factors that might have triggered the abrupt reversal.

Tech stocks have enjoyed a powerful rally this year, exacerbating concerns that the sector was sucking in investors chasing its performance and leading the industry’s stocks into overvalued territory, making a correction more likely.

On Friday both Goldman Sachs and UBS pushed out research notes with a sceptical view of tech stocks, which may have spurred some investors to take profits and pare down their holdings. Goldman’s analysts noted that while the free cash flow generation of the S&P 500 technology sector doubled from 2006 to 2016, it has since “plateaued”, making the 2017 rally less supported by fundamentals. Nvidia was also on Friday lambasted by Citron Research, a noted short-seller.

There are other indicators of classic valuation-driven investor rotation. For example, financial stocks and other sectors that have done poorly for most of 2017 have now enjoyed a rally.

Moreover, this week it emerged that Viking Global Investors, a big hedge fund, is returning $8bn to investors. The fund held big positions in Facebook, Microsoft, Alphabet, Netflix and Amazon, and liquidating some of these holdings to raise cash for investors could also have triggered the reversal.

But how could that have led to such a violent sell-off?

That is the mystery. Investor rotations happen all the time, but it’s rare they happen with such suddenness and ferocity without fundamental news to shift the investment narrative. The argument that so many investors suddenly and uniformly decided to up sticks and rotate into different segments seems implausible. So many analysts and investors are looking for alternative explanations.

While the Citron Research note might’ve started the short sellers piling onto Nvidia, it’s very difficult to attribute the entire selloff to just that. For one, the note said investors buy Google/Alphabet instead — which also slid in the tech selloff on Friday. And short interest in the five biggest tech giants only edged up by $187m in June 8-12, while there was $28bn of short interest ahead of the sell-off, according to S3 Research. The data provider concluded that it is “obvious that the two day tech slump was a long shareholder selloff and not due to short sellers driving down stock prices”

Instead, the changing nature of the investment industry and the impact on the stock market is the likeliest culprit. One of the main issues raised by the widely-read Goldman Sachs note was how tech stocks – and especially the big bluechips – had enjoyed a strong run with both strong momentum and little volatility. This made them vulnerable to a reversal.

“This outperformance, driven by secular growth and the death of the reflation narrative, has created positioning extremes, factor crowding and difficult-to-decipher risk narratives,” Goldman wrote. “Driven by the rise of mega-tech, momentum, as a factor, has built a valuation air pocket underneath it creating cause for pause.”

Pardon, “factor crowding”?

Let’s unpack this a little. An increasing number of institutional investors now use “factors” to allocate their money. Factors are the basic building blocks of market performance, and investors can try to cheaply and passively beat their benchmarks by tilting towards some that have shown to produce benchmark-beating returns over time.

Take “value”, one of the oldest and best-researched factors. Value stocks are solid but unfashionable companies trading below their fair value, and as famed value investor Warren Buffett has shown, buying good companies at a fair price is a good investment strategy in the long run.

Other popular factors are momentum – buying companies that have already risen in price, based on the observation that they tend to keep rising – and low-volatility, which is buying staid companies that tend to be unfairly overlooked by many equity investors.

What does this have to do with the tech tantrum?

Tech stocks are often classified as “growth” shares because they are usually fast-growing, racy companies. But the strong, steady run has meant they have also become “momentum” and “low-volatility” stocks at the same time. That would suck in billions of dollars worth of money allocated systematically to these factors as well, accelerating the rally but leaving it vulnerable to an abrupt reversal, Goldman Sachs noted.

Indeed, the correlation of the “FAAMG” stocks – Facebook, Apple, Amazon, Microsoft and Google – to the growth, volatility and momentum factors are in the 92nd, 90th and 96th percentile respectively, Goldman Sachs noted on Friday. Tech has this year been even less volatile than utilities, the traditional steady-Eddie stocks, storing up potential problems.

When tech began to buckle, reversing both their momentum and low-volatility factors, systematic funds would begin to sell, with nervous traditional mutual and hedge funds – which have piled into the sector this year – adding to the pressures.

Are these technical factors really such big drivers of the market these days?

Slowly but surely, the stock market has become a battlefield of algorithms, ranging from the simple – ETFs bought by retirees that may invest in the entire market, an industry, a specific factor or even themes like obesity – to the complex, commanded by multi-billion dollar “quantitative” hedge funds staffed by mathematicians, coders and data scientists. In the very long run fundamental investors tend to drive markets, but these systematic traders are having a mounting impact.

Marko Kolanovic, a senior JPMorgan strategist, estimates that passive and quantitative investors now account for about 60 per cent of the US equity asset management industry, up from under 30 per cent a decade ago, and reckons that only roughly 10 per cent of trading is done by traditional, “discretionary” traders, as opposed to systematic rules-based ones.

“Stocks are increasingly caught in powerful cross-currents of passive and quantitative investors,” he wrote in a note to clients on Tuesday. “While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals.”

Have we seen anything like this before?

The tech tantrum garnered wide-spread attention because it slammed such high-profile companies, but there have been a number of similar routs in recent years.

Last autumn there was a fierce sell-off in low-volatility stocks after rampant inflows into ETFs that track the factor, temporarily making these supposedly steady stocks even more turbulent than the broader stock market. Momentum stocks also suffered a fierce correction last spring, wrong-footing a host of hedge funds that had crowded into a bunch of similar, hot trades. These sell-offs also faintly echo a ferocious “quant quake” that struck the computer-powered investment industry in 2007.

Analysts say that these kinds of seemingly odd technical sell-offs and rallies will become increasingly prevalent as the algorithmic nature of modern markets continues to gather space.

So what happens to tech stocks now?

There cause for optimism. Tech companies are still as profitable as they were a week ago, and still sit on a $765bn pile of cash, UBS notes. And Mr Kolanovic reckons that the pressures from quantitative traders have now been played out. “The contribution coming from quant rebalances to this snapback is now likely over,” he wrote.

Of course, Goldman Sachs notes that free cash flow generation in the tech sector has stopped:

But the halted growth is mostly because of a rise in investment. That should be good in the longer run, and valuations are not anywhere near their heady levels from the dot com bubble.

Nonetheless, there are clearly simmering concerns over the level of the US stock market, given the unremarkable pace of economic growth. A record number of money managers polled by Bank of America Merrill Lynch say global equities are expensive, and the tech-heavy Nasdaq index was fingered as the most crowded trade.

While BAML analysts points out that this year’s rally has largely been driven by improving earnings, they admit that the recent trends are “worrisome” and point out that the US stock market capitalisation compared to US gross domestic product is approaching a new all-time high.

The brief but fierce tech rout shows how modern markets can quickly shift gears, notes Andrew Lapthorne, global head of quantitative strategy at Societe Generale.

“The sell-offs themselves are not particularly unusual, but the uniformity of the prices moves all on the same day indicates a market driven by price chasing momentum, with investors heading for the door all at the same time,” he argues. “For price chasing investors, Friday’s plunge serves as a warning; when it’s time to head for the door, you better move fast.”

Related links:
A lot of people think (tech) stocks are overvalued — FT Alphaville
‘Factor investing’ wages battle against history — Financial Times

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