A massive shift in the stock market from top-performing growth stocks to lower performing names triggered a sharp shift in “momentum,” and is crushing hedge funds this week.
Goldman Sachs said in a note that the decline “ranks among the sharpest on record,” and Morgan Stanley sent a memo to hedge-fund clients, seen by Business Insider, trying to explain the moves and saying the pain could well keep going.
“Everything that worked all year got sacked and whacked,” one quant hedge fund source told Business Insider.
“This has been a brutal move,” said another person at a hedge fund in London. “Huge move and lots of pain. It was like a 4 standard deviation day followed by another 4 standard deviation day. That’s unheard of.”
A Morgan Stanley sales desk sent a memo on Wednesday, outlining its traders’ take on “the magnitude and velocity of this week’s rotation.”
“All strategies are down,” Morgan Stanley said, warning that if the momentum “morphs” from short sellers covering to a wider selloff by longer term stock holders, “this is likely to spill over to the overall market.”
“If contained to a positioning unwind, the pressure should abate in a week or two,” the bank said. “But to be clear, the risks skew towards more derisking relative to historical unwinds, not less. The level of crowding remains high, portfolios are fragile right now, and should there be a fundamental shock, this unwind could persist for multiple months.”
“The longs are in the largest sectors of the market,” including tech and healthcare, “and underperformance there can bring a broader array of sellers.”
What caused this big shift?
“There was no single hard catalyst,” Morgan Stanley said. “The proximate causes were modest improvements in macro data” such as ADP’s US payrolls data, non-manufacturing activity, and the Citi Economic Surprise Index, as well as increased optimism about the US-China trade war and recent upticks in the 10-year Treasury yield.
“But it was really heightened risk aversion that caused the moves — investors were becoming increasingly nervous about P/L after underperformance from crowded areas,” such as software stocks as well as what it said was the underperformance of short sellers in the week after Labor Day. “A lot of investors trying to protect P/L and de-risk at the same time led to gaps that then accelerated and fed on themselves.”
The event brought up bad memories of the “quant quake” of 2007, driven by crowded trades that ended up thrashing giants like Renaissance Technologies. But the quant hedge fund source said that losses this time around were “not close to” those during the quake a decade ago.
Still, the memo detailed some scenarios that could exacerbate the problem.
Morgan Stanley said selling among long investors could happen if:
- “There is a decline in P/L that forces further degrossing (i.e. this just gets worse to the point hedge funds need to sell longs).
- There is a negative fundamental shock, investors realize that their longs in Growth and Tech are more cyclical than they expected, and they are forced to sell those holdings.”
Also ominous: Morgan Stanley’s CFO, at a Barclays conference on Wednesday, said that equities trading has been slow in the third quarter. The firm had originally said the third quarter was looking strong on trading.
A Morgan Stanley spokesman said the bank couldn’t immediately comment on the memo.