• Factor rotation was significant last week driving a large portion of the price action while the overall market was slightly up 0.6%
  • Growth underperformed Value by 2.4% over the past week representing a 2.5 standard deviation move
  • Previous Growth vs. Value pullbacks since 2017 have been 3-4% and the current pullback may exceed 4% given how stretched factor performance had gotten
  • In the near term (next 4-8 weeks), upside for stocks with high Growth and Momentum factors like Internet stocks may be capped. On a longer-term basis, this could represent an attractive buying opportunity for these stocks
  • Stocks/ETFs that have lagged before the current sell-off and have a high Value exposure could outperform in the near term. Financials (XLF) and Emerging Markets (EEM) fit the bill

Big factor moves over the past week

So much for a calm summer. The overextended and crowded parts of the market were exposed in force this week. The reversal of themes that performed well YTD hurt the performance of many hedge funds over the past week. The S&P 500 was up 0.6% on the week, but, below the surface, the shifts were much more extreme. On a factor basis, investors aggressively rotated out of Growth and Momentum and into Value.

Source: Koyfin.  Click here to create this chart on Koyfin.

ETFs representing Growth (IWF) and Value (IWD) are a good way to quantify the factor rotation happening. (You can monitor factor performance in the Koyfin factors dashboard.) Since the start of 2017, Growth (IWF) has outperformed Value (IWD) by 28%.  That represents the largest run since 2009 in such a short period of time. The severity of the move over the past week suggests that the Growth/Value factor reversal will take some time to play out. The typical pullback is in the ballpark of 3-4% since 2017, and it’s likely the current pullback from peak to trough will be larger and in the 4-6% range.

Source: Koyfin.  Click here to create this chart on Koyfin.

Growth sell-off represents buying opportunity

Has anything changed long-term? Probably not. For traders with a short term time horizon (less than 3 months), the current factor rotation is important to understand. For investors with a multi-year investment time horizon, the current pullback represents an opportunity to buy high quality stocks at a discount to where they were trading 2 weeks ago. Facebook (FB) was down 17% this week mainly because the company increased cost projections and disappointed on user growth. However, FB still dominates digital advertising, with 1.4 billion daily active users and 2.2 billion monthly active users ( ⅓ of the world population!). Twitter (TWTR) was down 21% this week because of disappointing monthly active user growth of +3% y/y and a slight decline q/q. However, daily active users increased +11% y/y, which is considered a more important metric than MAU when it comes to monetizing the user base.


Source: Koyfin.  Click here to create this chart on Koyfin.

Value segments like Financials and Emerging Markets may benefit from the factor rotation

The equities with high exposure to the Value factor and on the positive side of this rotation include segments like Financials (XLF) and Emerging Markets (EEM). These segments may benefit as the factor rotation continues.  On a stock level, JP Morgan (JPM) is an attractive candidate given its exposure to continued US growth and financial leverage. From a balance sheet perspective, JPM has $2.6 trillion of assetsand $260 billion of equity, or 10x leverage. On a very simplistic basis, if assets grow 3% next year in-line with US GDP, book equity will growth 30%. Obviously JPM’s assets are not all the same and the business lines need to be analyzed individually. However the pure leverage underscores the exposure to US growth. As a point of reference, analysts expect EPS to grow 45% in 2018 and 6% in 2019.

Growth factor is not the same as economic growth

Lastly, it’s important to make a distinction between the Growth factor and the general outlook for economic growth, especially since GDP growth was reported at a healthy 4.1% in 2Q on Friday. The Growth factor measures companies that are expected to grow earnings faster than the market. The performance of the Growth factor measures how much investors are willing to pay for high expected growth. Separately, the market’s outlook for future economic growth can be observed in several ways, one of which is to look at the relative performance of cyclical sectors like Industrials (XLI) or Materials (XLB) vs. the S&P 500. On these measures, the markets growth expectation have bounced from the lows. This makes sense after the strong GDP print and easing trade tensions on the back of the EU trade announcement.

Source: Koyfin.  Click here to create this chart on Koyfin.