Transitory Goldilocks

We noted at the beginning of the year that all of the positive event risk in 2023 was likely to be front-end loaded: headline disinflation, China reopening, tech sector cost-cutting, peak central bank hawkishness; and that in contrast to the prevailing consensus, H1 was likely to be much better for markets than H2, particularly as economic growth and corporate earnings were likely to remain resilient and investor positioning already reflected chastened appetite for risk. This remains our view. 

More than Buggin’s turn

Stock performance so far this year has been the exact opposite of last year, with most of 2023’s to date winners having previously more than halved in value in 2022. Earnings season has begun with companies missing on average outperforming those beating analyst estimates. We do not dismiss this as illogical, unfair, or even simply “Buggins’ turn”: 2022’s inflation winners are being sold to fund 2023’s prospective disinflation champions. The biggest beneficiaries of decelerating inflation and the avoidance of a hard landing in the West are the most marginal assets. This prospect of “Goldilocks” – however illusory - has resulted in a “dash for trash”.

Quant Momentum is smart, but not for bottoms

Argonaut follows an “earnings surprise” stock picking framework, which if successful, inevitably results in a high degree of “momentum” factor risk. JP Morgan¹ recently published detailed research observing quant factor style risk over the last 30 years, finding that “Momentum” has the best returns and about average volatility” but that “the major risk to Momentum strategies is its lag in adapting to changing market sentiment during inflection points.” This can be observed from Fig 1: Long/Short Momentum since 1994 which shows that the three significant drawdowns in the strategy occurring at market bottoms (2003, 2009 and 2020).

Fig 1: Long/Short Momentum since 1994

The reason for this is that anyone following a successful strategy during a market downturn is likely to find themselves long/overweight stocks with more resilient earnings and short/underweight lower quality assets which have borne the brunt of the earnings downgrade/derating cycle, meaning that the portfolio as a whole will have an abnormally low beta (See Fig 2: Beta of Long/Short Momentum since 1994) when the cycle turns up to the asymmetric benefit of the most marginal asset. Hence, positive inflection points are often the most dangerous time for any “Momentum” strategy.

Fig 2: Beta of Long/Short Momentum since 1994

Any process incorporating “Momentum” will therefore need a manual override at this point in the cycle. It follows that at market bottoms our strategy will need to not only run a more generous net exposure but will also be required to rebalance the factor exposure of individual stocks to neutralise our overweight in low beta and underweight in high beta stocks, also shedding the portfolio of high 12-month price momentum factor risk.

This requires an unemotional machine-like approach to stock-selection which is less backward looking than most fundamental analysis, anticipating a more benign macro. This feels uncomfortable since it is difficult to have a winning higher beta portfolio and realistically also be fully hedging market risk concurrently. Our intention is to avoid a negative correlation rather than target a market beta, and the fund will remain vigilant to risks. In our experience, however, our short book is usually a “canary in the coalmine” to overall market performance in that when high risk shorts are well-bid, there is usually limited downside to the market. Conversely, we should also get an early warning of a more difficult market, signalling time to press shorts again.

Inflation like Freddy Kruegar will likely return from the dead

We stick with our prediction that “Goldilocks” will prove transitory. Even in the high inflation era of the 1970’s there were bouts of disinflation where risk assets rallied hard. It is probable in our view that once inflation is pronounced dead (perhaps at some point over the summer) it will likely return - like Freddy Kruegar from “A Nightmare on Elm Street” – leading to a further problematic trade-off between economic growth and inflation and a further leg-down in markets. This is not a fight we wish to pick today. It is also important to recognise that whilst new bull markets have different leadership, bear market rallies often just see old favourites rally from lows, only to further disappoint. 

Man vs. Macro

Most investment strategies thrive only in certain market conditions with consistent outperformance being more a function of stable macro than manager skill. This is why few funds have delivered our double-digit positive returns in each of the last four years, and even fewer will achieve five years of consecutive gains. Macro regime change is always uncomfortable and adapting to new conditions can rarely be achieved with perfect synchronicity, but we remain confident that the fund can achieve its performance objectives for the year.

Barry Norris
Argonaut Capital
February 2023