Following a very difficult August and September for markets, the start of October has seen a market rally, but has proven to be a much more challenging period for alpha generation. Previously successful short positions have squeezed higher, as hedge funds attempt to close winning positions at the same time. Similarly long positions, while faring slightly better in comparison, have also come under selling pressure and underperformed as a result.
By analysing the broader market, the key factor to recognise though, is that this difficult period has not been as a result of a fundamental change, but rather a factor of mean reversion in the markets. This has important indications for what we can conclude from this period, and also as to what we can expect looking to the future.
Taking a look below at the top 30 outperformers during the period of the 28th Sept – 13th Oct provides clear evidence of what we believe to be a period of mean reversion.
The first set of price columns display the price performance over the recent market rally, with names ranked according to the size of their respective price increases. This information becomes interesting when taken into account with the second set of price columns, which show the price performance for YTD, prior to the recent market rally. When combined, these two sets of performance figures clearly show that the vast majority of outperformers have been those names which have previously been the main laggards in the market. In fact, the average gain since 28th Sept for the group has been almost identical to the average price decline YTD prior, albeit from a much lower base – an implication of this being, that in order to have made a material positive return on the vast majority of these names one would have had to been able to foresee the recent short squeeze with an almost perfect entry point, and also exit in short order if the rally is not sustainable. This is why short squeezes are difficult moments for active fundamental investors.
Taking the reverse of this analysis and looking at the top 30 underperformers over the two periods, provides further evidence that what we have seen has been a period of mean reversion. The table below shows that, with the exception of 3 companies, all of the main underperformers have been winners on a YTD basis, prior to recent market events.
Furthermore, looking at the average movements for the group across the two periods, while the period of underperformance has been sharp and violent, this has been more than offset by performance for the rest of the period YTD for the vast majority of names.
Given our investment horizon of 18 months on average, and our previous strong performance, it is inevitable that our portfolios contain a high degree of price momentum (as a positive derivative of earnings momentum). As such, whilst it has been a very difficult couple of weeks, this is to a certain extent unavoidable given we are not convinced it is possible to systematically identify these rotation periods. Even if we were able to, we would only be able to mitigate underperformance, rather than prevent it.
The good news is that without a fundamental catalyst this short period of mean reversion should not endure. We also remain committed to our current ideas, as no fundamental catalyst means no material changes to earnings stories – companies which we have concluded from our research will post earnings surprises on the upside will continue to do so, and the same on the downside, with prices readjusting in the future. Whilst short term periods of stock market performance where there is mean reversion based on no change in fundamentals are frustrating, these can often be the best entry points for new money into strategies based on fundamental earnings surprise investment analysis.
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