Six years ago, back in 2013, we presented what we then viewed (and still view) as the best trading strategy of the New Abnormal period, when we said that buying the most shorted names while shorting the names that have the highest hedge fund and institutional ownership is the surest way to generate alpha, to wit:
… in a world in which nothing has changed from a year ago, and where fundamentals still don’t matter, what is one to do to generate an outside market return? Simple: more of the same and punish those who still believe in an efficient, capital-allocating marketplace and keep bidding up the most shorted names.
Fast forward to today, when Bank of America confirms once again that with just one exception, the historically unvolatile 2017, going long the most shorted names and shorting the most popular ones has continued to be not only the most consistently profitable, alpha-generating strategy, but that in 2019 YTD, the top 10 crowded stocks underperformed the 10 most neglected stocks by 23%, the most on record!
One simplistic reason for this – besides the ones we enumerated six years ago – is that the most overowned stocks are generally clustered in either high growth or defensive/yield/low beta, leaving a broad swathe of high quality cyclical and value stocks neglected and inexpensive.
In the aftermath of the September quant quake, which sent growth stocks tumbling and value stocks soaring…
… and subsequent divergence in this formerly ironclad pair trade, which has also seen momentum stocks tumble to their lowest level in over two years as the recent turmoiling whiplash below the market’s surface crucified any moomentum-chasing funds…
… legacy popular, i.e. “hedge fund dinner” longs have gotten crushed, while the most shorted names have seen a tremendous rally in the past 3 months. This has also resulted in Goldman’s Hedge Fund VIP and “most concentrated” baskets getting pummeled in 2019.
It’s also why yesterday BofA speculated that with most funds underperforming the market and 29% underperformign their benchmark, “we could see a beta-chase into year-end if fund managers essentially “shoot for the moon”, driven by value stocks, to wit:
The recent market rotation from Momentum into Value should continue if macro data stabilizes – note that valuation dispersion is the highest we have seen since the financial crisis: we are seeing cycle-lows in relative multiples for Value stocks. Moreover, the fact that only 29% of funds are outperforming benchmarks could amplify the rotation if funds chase the Value rally. Active funds are still underweight Value at 0.89x.
There is another, more credible reason why such a contrarian strategy continues to be the best performing one: technicals, specifically crowding, and massive lazy bets among Wall Street professionals which, when unwound once a poorly-researched thesis collapses, result in a major overshoot in the opposite direction that is a gift to those who had the trade on.
Indeed, never has the power of positioning been more important than in 2019, when as BofA recently calculated, the overlap between positioning by mutual funds and hedge funds reached an all time high, and as a result, “positioning has been a big driver of returns in 2019” (we discussed this topic far more extensively back in April in “BofA Finds The Secret Recipe How To Consistently Beat The Market“)
The record concentration in holdings is also why Goldman back in August warned that “crowding is now one of the biggest market risks.” For once, Goldman was right.
To be sure, BofA also lays out its own three reasons why it believes that positioning has never been more important, and these include:
- crowding has become more extreme – the overlap between long-only (LO) funds and hedge funds (HF) is at record levels, and has been for much of this year; the relative valuation of momentum (what’s working) vs. forward P/E (neglected and inexpensive) is more than two standard deviations above average;
- a violent rotation from Growth to Value surfaced a few months ago,
- de-risking has been de rigueur: the aggregate net exposure of HFs has dropped from 56% to 40% this year as investors grapple with recession concerns. Add a few fund redemptions to the mix, and we can see the blueprint for a positioning-driven market.
And while BofA’s reasoning is correct, the big picture still stands: for anyone who wants to consistently make money in this broken market in which nothing is as it seems, and in which the vast majority is always wrong, the best way to do that is to do what we said back in 2013, namely to always bet against the crowd on both the long and short side.
The bottom line: when we said 6 years ago to buy the most hated names while shorting the most loved ones, we were right. As shown by BofA, this is how much alpha this strategy has returned in subsequent years:
- 2014: +17.8% (12.3% from shorts, 5.5% from longs)
- 2015: +12.6% (3.9% from shorts, 8.7% from longs)
- 2016: +7.5% (13.4% from shorts, -5.9% from longs)
- 2017: -10.6% (-9.5% from shorts, -1.1% from longs)
- 2018: +5.0% (0.4% from shorts, 4.6% from longs)
- 2019 YTD: 23% (10.1% from shorts, 13.3% from longs)
The question now is whether this apparently still obscure trade will finally stop generating alpha if more investors put it on. On the other hand, since by definition there will always be stocks that are “most crowded” and “most shorted”, this may be a strategy that is limited to those who are relatively small and nimble and can avoid moving the entire market. Which incidentally may be the latest reason why this is a market where smaller, contrarian traders will be rewarded even as the “whales” who trade based on idea dinner recommendations are doomed to fade into obscurity.
Wed, 11/06/2019 – 14:29
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Author: Tyler Durden