Friday, November 13th, 2020

Rotation, Inflection & Persistence

There have been a lot of rather breathless articles, proclaiming this week as the start of a great rotation within equities. The factors cited range from the standard momentum and value categories, to some which are altogether more exotic. We have no wish to deny the validity of these calculations, but they need to be interpreted with a degree of scepticism. There is always a factor which can be identified as having had a significant influence on a particular period of stock market activity on an ex-post basis.

However, this begs three important questions. First, is it reasonable to manage your portfolio, exclusively or largely on the basis of this factor? Second, can the interaction between the behaviour of this factor and events in the real world be predicted with a reasonable level of certainty/accuracy? Third, is the factor stable in the sense that once it turns, it carries on in the same direction for long enough to allow investors to exploit it? If the answer to any of these questions is no, investors should retain their scepticism.

We will discuss these issues on a sector basis, partly because all our work can be resolved down to three factors – momentum, minimum volatility and yield – and partly because the results will show up pretty quickly at a sector level if they are significant. We use three metrics, rotation, inflection and persistence, defined as follows:

  • Rotation: the gross total change in recommended sector weights resulting from our weekly rebalancing. We quote this as a four-week moving average (MAV);
  • Inflection: the point at which the 10-week MAV of the sector’s recommended weight (equivalent to 50 days) moves from a positive to a negative gradient or vice versa;
  • Persistence: the tendency for sectors maintain their position relative to other sectors; specifically, the number of consecutive weeks a sector spends in the top or bottom three of our recommendations.

Rotation in Europe: The biggest ever spike was recorded in April 2020, as the portfolio adapted to the sudden onset of COVID-19. It was bigger even than the spike in September 2008 during the GFC. Since then, the level of rotation has been extremely low, which the longest continuous number of readings in the bottom decile. There was a small spike in the last week of October and no doubt there will be another one this week, but we would still need several more big weeks to get back to the 25-year average.

Rotation in the US: There was a big spike in March 2020, but it was not as big as the ones in August 2011, September 2001 or October 1998. Since then, this metric recorded its 25-year low in July and has consistently been in the bottom decile since. There has been a noticeable uptick in the last two weeks, but these are both below average on a weekly basis. So, there will be an increase in rotation in the US, mainly because it couldn’t get much lower. We still have a long way to go to get back to the average.

Inflection in Europe: There are only three sectors in Europe where we have observed a significant inflection point in the last three months. They are Materials, from positive to negative, in November (i.e. now), Consumer Discretionary, from negative to positive, in October and Technology, from positive to negative, in September. Sectors like Industrials and Small Caps, which are suddenly attracting a lot of interest, changed from negative to positive in June. Others like Financials, Energy and Telecom, show no sign of shifting to a positive gradient and remain in the bottom three.

Inflection in the US: There are only two US sectors which have changed direction in the last three months: Technology, from positive to negative, in September and Utilities, from negative to positive, in October. Consumer Discretionary (i.e. Amazon) may be on the turn. The 10-week MAV has stopped going up, but it hasn’t actually gone down, even the though current weekly reading is below it. Communications turned down in early August but the current reading is above the MAV, which means we have a slightly mixed signal. There is no sign of a change in the bottom two: Energy and Financials.

Persistence in Europe: The current readings for the top three are a lot lower than the for the bottom three. The average for the top three (Materials, Industrials, Utilities) is 10.7 weeks vs 45.0 for the bottom three (Energy, Financials, Telecom). This is consistent with a well-established pattern, which shows that laggards remain laggards for longer than leaders remain leaders. The 25-year average is 13 weeks for the top three vs 17 weeks for the bottom. Tech dropped out of the top three two weeks ago, after a run of 39 weeks, but Energy is still in the bottom three after 76. The highest ever score for the bottom three was 47 weeks and it looks as though we will shortly break that record.

Persistence in the US: We see the same skew towards downside persistence as we do in Europe, only not quite as pronounced – 16 weeks vs 19 weeks. Technology is still in the top three after a run of 86 weeks, which means that the average score for the top three (including Consumer Discretionary and Materials) is 39.0 weeks, but this is still lower than the score of 48.0 for the bottom three (Energy, Financials and Utilities). As in Europe, we are close to breaking the 25-year record for downside persistence, which stands at 53 weeks.

Conclusions:

  • An extended period of stability in terms of sector recommendations is coming to an end, but the level of rotation is still well below its long-run average, so there is no need to panic or to get bounced into a series of trades on the basis of factors you don’t understand.
  • We think that the rotation will be from the top to the middle and vice versa. So far, we see no indication that the long run underperformance of Energy and Financials in the US and Energy, Financials and Telecom in Europe is coming to end. There will be exceptions – possibly UK Banks, if the Bank of England continues to avoid negative interest rates and all bets on the Energy sector are off, if oil goes to $60/bbl and stays there.
  • The inflection point in Technology in both regions happened in September, long before the US elections or the vaccine announcement. The impact of the factors which are attracting so much commentary now was identified by our process two months ago.

Leave a Reply

Full Blog Archive:


Other Recent Posts