May 29, 2023
Only days remain until the U.S. blows past its debt-ceiling deadline. On Saturday, President Biden and Republican House Speaker Kevin McCarthy reached a tentative agreement to prevent a destabilizing default. But passage of the plan, which could face some opposition in the House or Senate, isn’t yet assured and procedural hurdles could delay final legislation even if they don’t scupper it.
Despite the political uncertainty, the rebounding stock market has barely gotten nicked, with the S&P 500 finishing 0.3% higher last week. Over recent months, stocks have handily overcome stress in the banking system, stubborn inflation and interest-rate hikes. Last year, those kinds of issues repeatedly torpedoed stocks. This year, markets have met such events with a shrug.
The market’s steady rise has puzzled analysts and portfolio managers as the S&P 500 has churned more than 9% higher this year (and the technology-focused Nasdaq Composite has risen 24%). One explanation: Quant funds, or those relying on computer models and automated trading, have been doubling down on equity markets as other investors have stepped back, citing high valuations and concerns about the likely course of the U.S. economy.
Quant-fund buying has pushed these funds’ net exposure to U.S. stocks to the highest level since December 2021, according to data from Deutsche Bank. Mainstream investors, in contrast, have been pulling cash from stock funds and pouring it into money markets.
While providing a tailwind for stocks, these funds could also pose a risk should, say, the debt-ceiling deal unravel.
“If you do have concentrated positioning, it does create the risk of unwinds in the case of a negative shock,” said Christian Mueller-Glissmann, head of asset allocation research at Goldman Sachs. “And the risk you face with them is not just that they might have bought some equities because volatility has gone down—they might have levered up.”
The market has started to see early signs of eroding tranquility. Last week, the Cboe Volatility Index—the VIX, or Wall Street’s fear gauge—on Wednesday briefly settled above 20 for the first time in about three weeks as simmering debt-ceiling anxieties surfaced. Typically, anything higher than 20 indicates fear is starting to rise.
For now, though, the continuing demand from quants has provided a lifeline for the stock market. Combined with robust corporate buybacks, their buying has helped counteract selling pressure and led to placid moves. The S&P 500, for example, has moved less than 1% in either direction for 36 of the last 46 sessions, according to Dow Jones Market Data, the quietest 46-day stretch since December 2021.
“We have seen them sort of balance each other out for the last six or seven weeks now,” said Parag Thatte, a strategist at Deutsche Bank. He estimates that systematic and fundamental investors haven’t been this divergently positioned since 2019.
Driving the quant funds is a self-reinforcing dynamic. When market volatility drops, they pile in more. Big stock-market moves subsided this spring after regulators rushed to stem the banking crisis and the Federal Reserve signaled it might stop raising interest rates soon.
So-called vol-control and risk-parity funds, which tend to automatically load up on riskier assets during calmer periods, ramped up equity exposure, according to the Deutsche Bank data, available through May 18. Other quants, such as trend-following CTAs, or commodity trading advisers, have similarly piled in.
The dominance of quants has helped explain previous periods of calm trading, including long stretches in 2017 and 2018. Those periods were punctured by rapid selloffs, including the 2018 selloff dubbed “Volmageddon” when the dynamics exerting calm on the market suddenly went away. Some warn a repeat could be ahead.
Treasury Secretary Janet Yellen has said the U.S. could start missing payments on its obligations as early as June 5 if Congress doesn’t act. While investors have so far said they aren’t viewing the event as a key risk to stocks, other areas have been showing signs of worry. Investors have ditched short-term Treasury bills that could be at risk of missed payments, with yields on some bills maturing in early June topping 7% at one point last week.
Karl Rogers, chief investment officer at Elkstone, a Dublin-based investment firm, is among the non-quant investors who have been hesitant to jump back into the market. “We always thought 2023 was going to be quite volatile,” he said.
Rogers doesn’t believe inflation or interest rates will recede as quickly as investors expect, and thinks stocks will fall again as the economy worsens. Other investors are similarly worried about a possible recession, with a May survey from BofA Global Research showing that fund managers view it as the biggest tail risk for markets.
“The people who are really just looking at fundamentals, they are having a really hard time getting excited about this market,” said Patrick Ghali, co-founder of Sussex Partners, which advises institutional investors on hedge-fund investments.
Computer-driven trading isn’t new, and its influence has ebbed and flowed over recent years. A strong performance by quants last year has put them back on investors’ radar. At the end of March, quant-focused hedge funds held about $1.13 trillion in assets, according to research firm HFR, hovering just below last year’s record high. That represents about 29% of all hedge-fund assets.
Systematic investors’ foothold—combined with their tendency to move in lockstep—has often made them a target of ire. When markets unravel, investors are usually quick to blame the quants, whether justified or not.
“It’s rules-based trading,” said Charlie McElligott, a managing director at Nomura Securities International. “There’s no emotion involved.”
Data from McElligott shows quants tend to move together quickly when volatility strikes. Take, for example, the stock market selloff of May 2019, when the S&P 500 slid some 7% as investors panicked about U.S.-China trade tensions. McElligott estimates that CTAs unloaded $35 billion worth of equities over the course of a month.
Quants’ growing equity exposure could leave stocks similarly vulnerable going forward, McElligott said. However, he noted another possibility: Fundamental investors’ might instead increasingly chase a market that has gotten away from them. Already, there is evidence of increased buying from mainstream investors, according to flow data from major U.S. banks.
This article was originally published in The Wall Street Journal on May 29, 2023, and written by Caitlin McCabe. Image courtesy of FactSet. Peter Santilli/The Wall Street Journal.
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