I just completed a two-day roadshow meeting with our institutional investor clients in Boston/ Providence. The good news is that I found multiple instances where my fundamental equity long-only clients widened their YTD relative performance in the month of August (they bought the dip!). But a few issues seemed to keep popping up.

Foremost on their minds, at the moment, is a fundamental explanation for the violent rotations seen in the past few days, meaning significant shifts in (i) small-caps up >1% 3 days in a row after selling off 7% in August; (ii) rotation out of secular growth into cyclical stocks (cloud vs semis); (iii) reversal of high P/E secular growers vs low P/E value within sectors; (iv) surge in graveyard/zombie sectors plus the macro reversals of: (i) interest rate increase and (ii) gold sell-offs. Anecdotes include: “it seems like all sector and factor bets are now just a function of interest rate moves” and another “suddenly, the market changed its mind about secular growth at any price.”

Particularly given there has been little incremental macro developments to justify this. And in fact, many have cited work from other strategists that ISM and LEIs should continue to weaken—the most common data point being the ratio of new orders/inventory is weakening and that points to further weakness. Thus, why do seemingly “offensive” trades like cyclicals/inflation/small-caps suddenly have some life?

Many also pointed out that the Street is much more cautious now than it was a few months ago. Granted, this should not be surprising given ISM fell below 50, US yield curve inverted and talk of negative rates is not “happy talk” but many PMs also noted that Street strategists are now arguing for a persistence of PMIs to stay below 50 for some time. Take a step back—if the Street is cautious, and markets are rising, which one of these is “signal” and should be more reliable?

As I have written before, data shows that the long-term yield curve does a pretty good job of predicting ISM. The long-term yield curve (10M change of 30Y 10Y yield spread) signaled 16M ago a downturn in ISM PMI was coming (see chart below). And it currently suggests the ISM will fall towards 50 by 3Q19 but then soar to new highs in 2020.

Fundamental equity managers want to know…what’s up with these violent rotations?
Source: FS Insight, Bloomberg

This move upwards, in my view, is explaining the outperformance of Cyclical stocks.

Given the fact the sell-side remains quite bearish and consensus broadly got bearish in August (for valid but transitory reasons), I think much of the violent rotation is an “unwind” of this bearish positioning.

Fundamental equity managers want to know…what’s up with these violent rotations?
Source: FS Insight, Bloomberg

While some skeptics argue this is a mean reversion trade that will not last, I would argue the opposite. If the S&P 500 manages to make new highs (>3,025), this is a repudiation of the bearish thesis, exactly at a time when the bears thought their thesis was about to payoff big.

Like the wide world of sports, this is “defeat from the jaws of victory.” In other words, this would put greater credence to my thesis at start of 2019 that a “new bull market” is starting, similar to 2009.

What could go wrong? Macro risks are elevated. The biggest risk is an escalation of the trade war and White House overall.

Bottom line: I see a rally in 2H19, taking the S&P 500 above 3,125, which is 5% higher than current levels (see chart above).

Fundamental equity managers want to know…what’s up with these violent rotations?
Figure: Comparative matrix of risk/reward drivers in 2019
Per FS Insight
Fundamental equity managers want to know…what’s up with these violent rotations?
Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019

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