What investors can learn from 2021’s most popular trades
One of the questions investors ask us most often is “When does a crowded trade become too risky?” Biologists will tell us that the movement pattern of herds is exceptionally hard to predict, but occasionally there is a clear trigger - a predator or a change in the landscape that causes a shift in direction. In financial markets, shifts of the market herd from greed (i.e., buying into crowded trades) to fear (i.e., stampeding to exit those trades) are often linked to a given fundamental factor (such as industry supply/demand) or to discount rates (incorporating interest rates and risk).
Staying ahead of the shift from greed to fear is not easy (although finding a way to do so will only become more important as global liquidity adjusts to a more normal environment). Greed periods often last a long time, as the market steadily prices in information. But fear takes shape quickly. When the market herd starts to move to exit a trade, the resulting downward price action tends to reinforce the impulse to exit; a rapid downward spiral follows.
In Active Quantitative Equity, we evaluate popular segments using a balanced approach to stock selection, which takes a range of key market drivers into account, including value, quality, sentiment, and risk. At the same time, we work hard to anticipate catalysts - key changes in the market’s view of future fundamentals - in an effort to decipher when investors will shift from greed to fear.
In general, crowded trades exhibit a relationship between ultra-high sentiment, poor value, and potentially falling quality.
Among these characteristics, sentiment is the most crucial to watch, because it serves as a proxy for future fundamentals. The detonation of ultra-high sentiment signals that it’s time for investors to leave the party. Value factors can provide some warning signs, but the history of value timing is fraught with alarm bells that go off too early.
With this background in mind, let’s take a look at some of the most interesting winning trades in 2021. Examination of some of the good performers that have historically been mean - reverting can help to illustrate how we think about these type of investments.
Emerging Market Marine Transport (One-Year Return: +215%)
The Marine industry, which is composed of global shipping companies (up 100%, YTD) has been one of the most popular segments of the market in 2021. The shipping sector often goes through boom/bust cycles; investors in shipping stocks often flee after a rally. Nonetheless, our models indicate solid fundamentals that continue to support our positioning. After the global financial crisis of 2008, the industry suffered through years of overcapacity that subsequently led to a period of aggressive consolidation and capacity reduction. With the boost in global economic activity, pricing power has returned. Our models continue to favour these stocks from a sentiment and quality perspective, with only a mild ‘yellow light’ from valuation. Market risk measures are rising, however, so we will need to monitor this one carefully.
World Semiconductors (One-Year Return: +62%)
End consumers have rarely spared a thought for semiconductors, but that has changed this year. Underinvestment in the relatively unglamorous realm of semiconductor fabrication now means that industrial firms (from autos to watches) are facing severe shortages. This has granted chip makers an unprecedented level of pricing power. Investors have understandably been drawn to these higher margins and even higher demand. Leaders in the industry such as Intel and TSMC have committed to adding new facilities to improve production capacity, but these are likely to take years to bring to scale. Our model signals continue to support an overweight, driven by highly favourable quality and sentiment scores, tempered only mildly by neutral valuation and risk metrics. Semiconductors may have some room to run, especially as Asian tech investors flee their Chinese positions.
Chinese Consumer Discretionary (One-Year Return: -13%)
We wrote about the selloff in Chinese consumer discretionary stocks in last month’s commentary. These names continue to sell off - but we are still not buyers. At the margin, this segment is certainly getting less crowded, but valuation metrics for most of these stocks are still twice that of the overall MSCI China - especially the large-cap names that are under regulatory scrutiny. We like the China consumer growth story, but prefer names in the less crowded, small-cap segments that offer better valuation and better near-term fundamentals. These will likely face fewer administrative headwinds and may benefit from some of the ‘Made in China’ industrial policies.
The Bottom Line
In Active Quantitative Equity, we focus on keeping a balance between the key forces – value, sentiment, quality, and risk - that drive markets. Strong performance in one or more of these areas can justify maintaining a position in a crowded trade, even when performance in other areas is weaker. By taking a holistic view of these key market drivers, we strive to reap the rewards of crowded trades while staying ahead of the potential shift to fear.
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