SUMMARY: Economic growth is much firmer than expected, increasing the RISK that financial conditions need to tighten plus, New York Community Bank is down almost 60% in 5 trading days, and investors are debating how far Chinese authorities will go in supporting equities. FYI: John Roque noted yesterday that the “price action suggests a tradable bottom is coming together in China”. Uncertainty is high near term, which lends itself to mean reversion. Most of what worked in December ‘23 (small caps, value, Deep Cyclicals) significantly underperformed in January ‘24.
Simply going long the 6 worst-performing industry groups of the prior month and short the 6 best-performing groups has had positive returns consistently since 2021 (10.7% annualized l-s return). Another mean reversal in February would favor long Tech Hardware, Consumer Durables, Materials, REITs, Autos, and Utilities. Media, Semis, Household Products, Insurance, and Telecom would be fades on the month.
GARP IS “WORKING” – IF You Don’t Have Small Size or Earnings Risk Exposure: During 3Q23, which looks like a similar backdrop to today (for now at least), our SMID cap GARP portfolio was dragged lower by size and risk positioning. The GARP contribution was positive. Bottom Line: If you are confident that economic growth will cool, without a significant tightening in financial conditions, GARP exposure with small size and Earning Risk will benefit. I.e., the pain has already been felt. If you are unsure how the economy will play out or think financial conditions need to tighten materially, GARP + Quality exposure would be best. FYI: GARP + Quality had the best risk-adjusted return during 3Q. We are happy to send both stock lists along…
We close out today with a note on the record $42B 10yr auction and the supply of public debt. A continued rise of the federal debt is a tail risk, but a conventional look at fiscal sustainability does not indicate fiscal consolidation is necessary right now. Details in the full report below…
Full report below…
MARKET VIEWS: Investor focus is on economic growth that is too strong (increasing the risk the Fed needs to tighten FCI), the sharp decline in NYCB, and how far Chinese authorities will go in supporting equities. FYI: John Roque noted yesterday that the “price action suggests a tradable bottom is coming together in China”. Unfortunately, the current backdrop tends to lend itself to mean reversion. Our dummy portfolio that goes long the 6 worst-performing industry groups of the prior month and short the 6 best-performing groups has had positive returns consistently since 2021 (10.7% annualized l-s return). If US monetary policy uncertainty is elevated, which seems to be the case near term, mean reversion is a risk to portfolios.
If mean reversion trends persist, long Tech Hardware, Consumer Durables, Materials, REITs, Autos, and Utilities would benefit. Media, Semis, Household Products, Insurance, and Telecom would be fades on the month.
WE STILL LIKE GARP: Our favorite fundamental factor is GARP (see the 2024 Outlook for more details). During 3Q23, which looks like a similar backdrop with today, our SMID cap GARP portfolio was dragged lower by size and risk positioning. The GARP contribution was positive, but exposure to those risk factors hurt. If the market continues to trade like 3Q23, fundamentals will still deliver alpha, but risk exposures will need to be neutralized.
The factor allocation that would’ve generated the best return during 3Q23 was GARP + Low Vol. However, that would’ve required timing the runup in yields. Right now, similarly, Low Vol positioning would require confidence in the path of economic data. If you are confident that economic growth will cool, without a significant tightening in financial conditions, GARP exposure with small size and Earning Risk exposure will benefit. I.e., the pain has already been felt. If you are unsure how the economy will play out or think financial conditions have material risk to tighten more, GARP + Quality exposure would be best. FYI: GARP + Quality had the best risk-adjusted return during 3Q. We are happy to send this list of stocks along…
PUBLIC DEBT: There is a record $42B 10yr auction today, so we thought it would be a good time to talk about UST supply concerns. As Gerard noted in a report yesterday (HERE), estimates of trend growth (g*) is still above estimates of the neutral rate of interest (r*), which would suggest a shortage of public debt. With a continued rise of the federal debt, there is a good chance that the forward path of r* will rise meaningfully above g*, which would be a signal that fiscal consolidation is in fact required. But right now, the conventional way of measuring fiscal sustainability downplays the tail risk. If inflation risk starts to increase again, estimates of r* would increase, and UST supply would be more difficult to absorb. Like we saw in 3Q23.
