This Isn’t a Pullback - It’s a Quant Unwind and a Full-Blown Rotation

Today, it’s time to take a look under the hood of the market, as a few fascinating things have happened that are all critical to my “Big Picture” research and asset allocation.  The interesting part is that, on the surface, it really looks like the market is “business as usual,” as both the S&P 500 and its equal-weight peer, the RSP (that’s the ticker of the equal-weight ETF), are near all-time highs.  However, we are dealing with a “quant unwind” that has done substantial damage to the momentum trade. This happens at the same time as a recovery in what I like to call the “real economy” for the first time since the end of the pandemic.  This creates a scenario where money is essentially being forced out of crowded, more fragile trades into areas that didn’t get any love for more than three years. As dramatic as it may sound, that’s a regime change.  Now, let me give you the details and explain what that means for me (and you)! Let’s Discuss The "Dead Zone" and Market Fragility Since ChatGPT became mainstream at the end of 2022, we basically had a forced capital rotation from value to growth stocks. This was driven by two very straightforward factors: Cyclical economic growth started to decline. I am talking about the leading ISM Manufacturing Index, various regional surveys that supported it, a weakening housing market, poor consumer sentiment, and similar indicators.  The emerging AI revolution created a new multi-trillion-dollar industry out of thin air. For investment managers, the choice was easy to jump into AI, as it had secular growth, while the real economy was too risky.  As a result, the market’s biggest 10 companies (mostly consisting of Mag-7 stocks) accounted for roughly half of the market’s returns in recent years, pushing their weighting to roughly 40% of the S&P 500.  [Inline image] Source: JPMorgan There’s nothing wrong with that. After all, we’re talking about some of the best innovators like NVIDIA (NVDA), Alphabet (GOOGL), and Tesla (TSLA). They deserve capital.  However, we are now at a point where these have lost momentum. Since October, many of these companies have gone nowhere. Year-to-date, we have even seen an entire rotation, as energy, materials, and even consumer staples are now leading the pack with returns of more than 10%. Meanwhile, information technology is down slightly more than 1.0%.  [Inline image] Source: State Street As The Bear Traps Report wrote in an institutional research paper:  Every day, we are told the "market is making all-time highs." Yet stocks have been unchanged since October. This is a classic bull vs. bear battleground. If the bulls fail to take the market to new high, selling will violently accelerate.  They make the case that this is a quant unwind in factor land. Or, in other words, we have seen a systematic de-grossing where momentum and growth factors are being sold to fund growth into value. It’s a fancy way of saying large funds have been freeing up cash for value investments by selling their winners in other areas.  To make things even more technical, we’re dealing with some dangerous developments in the overcrowded tech trade, as Micron (MU), which is a memory company I actually like a lot, has a call-to-put ratio of 10:1, which means there’s a lot of short-gamma fragility. This means the slightest sign of a reversal can send these OTM calls into oblivion.  This explained some of the carnage in recent days. The tech trade was on thin ice.  As bullish as I am on Micron’s earnings on a long-term basis and its dominant position at the new AI bottleneck called memory, its 19% reversal in a few days shows this has become a thesis with a very poor short-term risk/reward.  [Inline image] Source: StockCharts (MU) Completely unrelated to this specific market, these developments show why I always tell new investors to avoid chasing momentum. These vola