Is today's the day someone - following the suddenly resurgent VIX - finally blows up? Here are some timely thoughts from RBC's head of cross-asset correlation Charlie McElligott.
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Why Energy Teams Are Getting Blown Out
THE ENERGY / ‘VALUE’ MARKET-NEUTRAL / MEAN-REVERSION MELTDOWN: Currently, we see crude scrambling-higher despite last night’s bearish API’s and generally weak price-action as traders began fading the ‘9 month extension’ story as many instead continue to focus on ever-ramping US shale supply (word of warning: OPEC trades the market like no other, I would be shocked if they were keeping an additional ‘further production cut’ in their back-pocket (in conjunction with the extension) to catch the market with flat-footed expectations into their policy announcement).
The “real” fireworks off the back of the crude move however have come in the energy equities space, specifically within the market-neutral community. Since the start of the year, the energy sector (-10.2% YTD) has come unglued, spending the majority of 2017 as the S&P’s worst-performing sector (although currently we see ‘Telco’ holding the title -11.6% YTD) after having finished 2016 as the S&P’s BEST performing sector (+23.7% in ’16).
What I have simultaneously been noting (again most-recently just yesterday) is the YTD destruction of ‘value’ factor market neutral (long ‘value’ short ‘growth’) after it too exploded higher in the back half of ’16, as a near-decade of central bank interest rate volatility suppression saw a reversal from the ‘lower / flatter forever’ narrative. You might recall this chart from last week, highlighting the ‘value / growth’ ratio trading inversely correlated with US Financial Conditions Index, as ‘easy’ conditions and pinned-rates saw investors search for yield via ‘secular growth’ and / or ‘bond proxies,’ which has once-again ‘thematically flourished’ in 2017:
The Fed / QE killed ‘value,’ as ‘value : growth’ ratio inversely correlates to ‘easy’ US financial conditions
The second-largest 110d (essentially, YTD) move lower in ‘value : growth’ ratio since 2009
So how does this tie back into energy equities? Well, with ‘energy’ as a ‘cyclical’ and ‘deep value’ poster-child after the multi-year deflation crisis, it clearly got popular last year, and fast (i.e. ‘momentum’) per the aforementioned ‘best S&P sector performer in 2016’ datapoint and the fact that ‘value’ factor saw the largest ‘smart beta’ ETF inflows of 2016 at +$8.6B.
Well, things began going south around the Fed hike in mid Dec, which marked the top of nearly all thematic ‘value market neutral’ / ‘cyclicals vs defensive pairs’ trades, largely in conjunction with the USD ‘peak.’ And of course, 2017 YTD, both ‘value’ market neutral and the US ‘energy’ sector have been an outright sale as ‘reflation’ themes have bled-out with Trump’s fiscal policy failures / inability to push rates and inflation expectations higher. As you can see clearly below, energy (XLE) has tracked ‘value market neutral’ (12m) to perfection:
It should then be noted too that $ flows into ‘value market neutral’ smart-beta ETFs began to reverse after peaking in start January ’17, and for the month of April, have actually seen OUTFLOWS in ‘value’ smart beta for the first time since February ’16, as investors throw in the towel on ‘reflation’:
More recently, popular QoQ ‘mean-reversion’ stat arb strategies have been gutted (see my ‘mean-reversion’ proxy below, -4.0% QTD after starting April +1.3% at one point). This is relevant to the ‘energy’ sector as it was the worst performing sector in Q1 and thus would have been part of the ‘long leg’ in any such mean-reversion strategy:
Long story short, I think there is now enough of a fact-pattern established here to connect the major strains in ‘value market neutral’ strategies (-5.8% YTD, worst performing factor strategy in Dow Jones M/N index universe), mean-reversion stat-arb strategies (proxy -4.0% QTD) and energy sector market neutral book ‘blow-ups,’ with speculation of multiple teams shut around the Street since April.