Last week was one of the most active weeks in the market in years, but you wouldn’t guess it from looking at the weekly chart of the S&P 500, which the C Fund tracks:
This was a relatively flat week overall, with a mild slump early in the week followed by a small rally and then another mild slump to close out the week. However, under that relatively smooth surface, there has been a tempest of activity.
First of all, this week saw the biggest upward reversal in bond yields since 2016. A week and a half ago, the 10-year treasury note was yielding 1.47%, and now it has jumped all the way up to 1.90%:
This reversal included other types of bonds as well, and made the F Fund fall more than 2% since September 4th, which is quite a big drop for a bond fund in just a week and a half. This is because bond prices move inversely to bond yields, so rising bond yields mean falling bond prices. Bonds and bond funds with longer durations of 10-20 years or more took an even bigger hit. The G Fund is immune to these price drops, and will mildly benefit if rates remain elevated for some time. Mortgage rates went up as well, and gold prices dipped.
While a move like this can have many causes, a series of not-so-bad economic reports came out this past week, the ongoing trade war eased tensions with some brief tariff delays, the core inflation rate moved up a few points, and the European Central Bank resumed monetary stimulus efforts, so the market seems to have relaxed a little in the near term.
It was becoming a crowded trade for fund managers to bet heavily on long-duration treasuries in expectation of lower and lower yields, and it may have been too much too fast.
This reversal affected stocks as well, to an even sharper degree. Over the past five years, momentum stocks have completely outperformed value stocks and virtually every other asset class, including the broad S&P 500. This chart, for example, shows the iShares Momentum ETF outperforming the iShares Value ETF by 58% over the past five years:
All of the stocks in these two funds are within the C and S Funds.
The momentum ETF has a large weighting towards technology and has an average price-to-earnings ratio of over 30 and a price-to-book ratio of over 6, which is quite high. These are mostly fast-growing and mostly high-quality companies that have strong upward price trajectory and a lot of investor enthusiasm.
Meanwhile, the value ETF has an average price-to-earnings ratio of less than 17 and a price-to-book ratio of about 2.3, which is far cheaper. It has a big weighting towards slower-growth financials and other sectors that have underperformed recently.
Well, in recent days, value had its biggest week of outperformance over momentum in years, with a positive 4% performance gap. Value went up and momentum went down:
This value/momentum reversal happened for a couple reasons. The first one is that financial stocks like banks benefit from higher interest rates and are in the value end of the spectrum, so the shift in bond yields and mortgage rates led investors to flock into them. The second reason is that growth stocks generally benefit from lower interest rates, because a large portion of their expected cash flows are in the future, and lower discount rates give them higher fair valuations for those expected cash flows.
Many hedge funds use high amounts of leverage on these trades, and some of them were long momentum stocks, long bonds, and short value stocks, so this sharp reversal has sent ripples through the investment community.
Whether this reversal is temporary or a start of a longer trend to higher bond yields and better relative value stock performance is anyone’s guess. Investors that focus on the rate of change of various economic indicators are still seeing continued economic growth deceleration, which implies that this may just be a temporary reversal due to investor sentiment (rather than hard economic data) and that it is likely to revert back to the trend of lower yields. On the other hand, if economic data start to pick up, we could indeed see a more sustained reversal.