Chart of the Day - "Great Rotation" from Institutional Investors to Private Clients

"For a traveler going from any place toward the north, that pole of the daily rotation gradually climbs higher, while the opposite pole drops down an equal amount." - Nicolaus Copernicus

As we enter the "Sell in May" period, it looks like Insitutional investors have continued to be net sellers for the last five consecutive weeks and are, according to Bank of America Merrill Lynch from their recent Equity Client Flow Trends report of the 29th of April. Institutional investors have been the biggest net sellers year-to-date:

"Net sales by this group last week were their largest since January and the fourth-largest in our data history (since 2008). Hedge funds were net buyers for the fourth consecutive week, and private clients also continued their net buying streak. Clients sold both large and small caps but bought mid caps last week; year-to-date only small caps have seen outflows." - source Bank of America Merrill Lynch

Arguably the Chart of the Day is indeed the "Great Rotation" from Institutional Investors to Private Clients from 2008 to present:

- source Bank of America Merrill Lynch

From a shorter term perspective the "Great Rotation" by client type is as follows as per Bank of America Merrill Lynch's recent report:

"Weekly flows by sector, client & size (4/21-4/25)

Net sales last week were driven by outflows from Energy, Health Care and Financials. Tech saw the largest net buying amid better-than-expected earnings results from most companies in the sector. Discretionary and Telecom were the other two sectors that saw inflows. Tech is the only sector which has seen two consecutive weeks of net buying; Utilities has the longest net selling trend at five consecutive weeks.

Institutional clients led net sales last week, while both hedge funds and private clients were net buyers. By size segment, outflows were chiefly from large caps but also small caps, as only mid caps saw inflows." - source Bank of America Merrill Lynch

What is for us of interest is that we have been tracking for some months the convergence between Small caps and Utilities as displayed in the below Bloomberg graph showing the Russell 2000 index ratio to S&P 500 against the S&P500 Utilities Index ratio to S&P 500:

Although Utilities are seeing net selling trends, they are no doubt outperforming Small Caps' relative performance against the broader S&P 500. 

We have been tracking with interest this convergence since beginning of 2014. This convergence should accelerate in the coming weeks as shares of smaller companies may be especially vulnerable to declines with market volatility rising, particularly valuation wise given that according to Bloomberg, the Russell index's price-earnings ratio increased to 49 in 2013 from 30 at the end of 2012. Russell 2000 companies have a median market capitalization of around $692 million versus the median value of $15 billion of the S&P 500 according to Bloomberg data.

On another note, shares of these smaller companies are destined for further declines in conjunction with the Fed's tapering which first impacted large capitalization companies, which have been more sensitive to interest  rates such as Utilities. This is reflected as well in the above graph.

"The glory that goes with wealth is fleeting and fragile; virtue is a possession glorious and eternal." - Sallust

Stay tuned!

Why have Global Macro Hedge Funds underperformed?

"There is no better than adversity. Every defeat, every heartbreak, every loss, contains its own seed, its own lesson on how to improve your performance the next time." - Malcolm X 

Many pundits have recently looked at the lackluster performances of Hedge Funds from the European crisis perspective. We would like to have a different approach, namely the one of volatilities.

Courtesy of our good friends at Rcube Global Macro Research, the answer appears to be more simpler. It's the volatility stupid! Or lack thereof....

"Volatility across all asset classes has crashed. As the chart below highlights, when this happens, global macro strategies tend to suffer on both an absolute and relative basis."

"While investors have poured massive amounts in long equity volatility products over the last 9 months, as a hedge against long stocks exposure, this strategy failed spectacularly. We believe more pain lies ahead for long equity volatility trades."

We would like to highlight an interesting pattern on VIX future, illustrated by the following kernel regression analysis between these variables:

X: the sum of 100 days Z-Score of the S and P500 Index and the SPVXSTR Index (a rolling long VIX strategy, tracked by the VXX ETF).

Y: Annualized expected returns of the SPVXSTR Index

We see that when we are at the lowest of the range (meaning that volatility does not react to a market dip, which is currently the case), further weakness should be expected on vol forwards. 

Regarding other measures of sentiment/positioning, investors still seem to be extremely defensive while stock markets have substantially rallied over the last few months. This remains the most hated bull market in recent history. 

Classic measures of sentiment are still deeply negative and at levels that are usually reached after medium to long term bear markets.

The CBOE put call ratio reached historical highs on both the 10 and 90 days sma last week:

Stocks have very substantially lagged credit this year. We have advertised in recent publications why

we believe corporate credit outperformance is over.

The recent sharp improvement in US consumer sentiment doesn’t seem to have been priced by the stock to bond ratio.

We are also aware that earnings revisions have been on the weak side recently.

In addition to the great points made by our good friends from Rcube, with interest rates at zero it is as well very challenging for Global Macro Hedge Funds to play an economy against another in currencies markets due to the fall in volatilities.

To bring some solace to Global Macro Hedge Funds, their biggest liquidity and volatility providers, namely   top investment banks, are suffering as well, as reported by Neal Amstrong article in Bloomberg - Biggest Traders Hurt as Fed to ECB Crush Volatility - on the 23rd of November:
"The world’s largest currency traders say foreign-exchange revenue is sliding as central-bank policies stifle price swings and cut volumes by $300 billion a day. Deutsche Bank AG, the biggest dealer based on Euromoney Institutional Investor Plc data, says narrower margins cut revenue “significantly” last quarter. Barclays Plc, the third-largest, says foreign-exchange sales are dropping and fourth-placed UBS AG says it has been hurt by lower volatility. Daily turnover as measured by CLS Bank, operator of the largest currency-transaction settlement system, slid 6 percent to $4.72 trillion in the third quarter from the year-earlier period. The combination of interest rates at, or near, record lows in the U.S., Europe and Japan is diminishing the allure of the dollar, euro and yen, the three most-traded currencies. From Switzerland to Brazil, central banks are establishing controls on exchange rates, making it less lucrative to trade the franc to the real. “With interest rates being at zero it’s very difficult now to play the cyclical differences in economies,” David Bloom, global head of currency-market strategy at HSBC Holdings Plc in London, said in a telephone interview on Nov. 20. “We’re in a structural world where if you have an economic event, you are best placed to think about it in terms of equities or bonds rather than foreign exchange.”

"Past performance speaks a tremendous amount about one's ability and likelihood for success."
Mark Spitz

Stay tuned!