Inside Markets — Wall of Worry

Yesterday’s hotter than expected core CPI print resulted in higher bond yields, which may have temporarily interrupted the unwinding of a very crowded momentum trade. Momentum has outperformed the other three main equity factors for the last ~9 months and positioning has reached extreme levels. Momentum is a dynamic equity factor that changes in composition based on broad macro trends. The momentum factor is currently composed of mega-cap Tech stocks on the promise of future rate cuts, but for most of 2021, the factor was composed of value sectors on the promise of higher real yields. An eventual shift in the composition of the momentum factor should precede a change in macro conditions by several weeks. And a shift in the composition of momentum starts with the factor losing its leadership position among the others. Momentum continues to lead this rally, but crowded positioning increases the risk of an eventual unwinding that’s likely to trigger a broad pullback (>5%) in equity markets.

A momentum driven bull market can last a long time and usually ‘climbs a wall of worry.’  In the current environment, the incomplete list of worries includes: 1) evaporating Fed rate cut expectations; 2) extremely restrictive real yields; 3) nominal 10-year yields north of 4%; 4) crowded positioning; 5) bubble fears and; 6) upcoming US election cycle. None or all of these worries may be justified, but their relevance is usually only recognized by equity markets when volatility spikes. In VIX terms, problematic levels of realized equity occur at or above 20. The VIX currently sits at benign levels in the low-teens.