The unprecedented divergence between the performance of various equity market segments offers a once in a decade opportunity to position for convergence, say Marko Kolavonic and Bram Kaplan, quantitative strategists at J.P. Morgan in New York.
Kolanovic and Kaplan point to a record divergence between value/cyclical stocks on one side and low volatility/defensive stocks on the other. The level of divergence is even greater than the dot com bubble valuations of the late ’90s; the Chart shows the valuation difference (in forward P/E) between value and the broad market, as well as between value stocks and low volatility stocks).
While they accept there is a secular trend of value becoming cheaper and low volatility stocks becoming more expensive due to a secular decline in yields, Kolanovic and Kaplan think the nearly vertical move of the last few months is unsustainable. Given the extreme divergence they think that something as little as hedge funds increasing net and decreasing gross exposure during a summer rally could trigger this rotation. They point out that hedge funds’ net is low due to the high level of shorts, most of which come from cyclical and high volatility stocks. This could, in turn, trigger a chain reaction of short covering, fundamental flows, and equity long-short quant rebalances in a low liquidity environment. This rotation would push significantly higher all the laggards such as small caps, oil and gas, materials, and more broadly stocks with low P/E and P/B ratios.