The market sell-off in October reflected investors’ concerns with the sustainability of economic growth, the longer-term impact of trade tariffs and rising interest rates. In all, it appeared to be a shift away from pro-cyclical factors and sectors to defensive ones. The MSCI Factor Crowding Model indicated the potential for continued risks to pro-cyclical themes, even after the sell-off.
The global view
Using MSCI’s Barra® Global Total Market Equity Model for Long-Term Investors (GEMLT), we observed that the general pattern in October was a rotation away from riskier stocks (i.e., moving out of those with higher historical beta and residual volatility into larger capitalization, higher dividend yield stocks). As we see below, the underperformance of the volatility factors across various regions stood out, particularly in the U.S. What is notable is that, unlike previous market sell-offs when investors preferred safety and quality over value, this time the value factors posted either flat or positive returns and outperformed the quality factors.
Data from October 2018
Global sector performance highlighted rotation
Similarly, industry factor performance in October reflected investors’ rotation from more economically-sensitive, pro-cyclical sectors, such as materials and industrials to more defensive-oriented ones, such as utilities, consumer staples and telecommunications.
Although the rotation to defensive factors and sectors was particularly severe in October, the fact is it started much earlier this year, as can be seen in factor and sector performance below.
Factor and sector performance show earlier signs of rotation
Data from January 2018 to October 2018. “Cyclical Factors” is represented as the equally weighted combination of the MSCI World Momentum Index, the MSCI World Equal Weighted Index and the MSCI World Enhanced Value Index. “Defensive Factors” is represented as the equally weighted combination of the MSCI World Minimum Volatility Index, the MSCI World High Dividend Yield Index and the MSCI World Quality Index. “Defensive Sectors” is represented as the free float market capitalization weighted combination of the following MSCI World Index sectors: energy, consumer staples, health care, telecommunications and utilities. “Cyclical Sectors” is represented as the free float market capitalization combination of the following MSCI World Index sectors: materials, industrials, consumer discretionary, financials, information technology and real estate.
Momentum continued to show crowding
Despite the negative return of the momentum factor in October, we continued to observe the high levels of crowding we highlighted in August. Some components of the factor remained elevated or increased, such as valuation spread and pairwise correlation, while others decreased, such as short interest spread.
Mind the undertow
Whether you look at October in isolation or back to the end of June, it appears the tide may have already turned. Our analysis observed a shift in the market toward more defensive stocks and the potential for continued risks to pro-cyclical themes.
The authors thank Peter Zangari and Dimitris Melas for their contributions to this post.