The Flip Trade
The announcement by the European Central Bank (ECB) that it was considering even more monetary policy stimulation before the end of this calendar year continues this sustained period of asset market support. Just as Europe was showing signs of stimulation fatigue – which we define as little growth from massive economic support – the ECB stumbles upon a new idea – more asset price stimulation!
In a running battle of economic largesse the Chinese administration also moved to support its financial system on the weekend with lower interest rate settings. The US Federal Reserve continues with its default position of doing nothing to adjust its historic low cash rates. Meanwhile the Japanese Central bank continues its asset purchasing policy as if it has no tomorrow.
All these policy announcements immediately caused gyrations on world bond and equity markets. Noteworthy was another rally in European junk government bonds (Italian 10 year bonds rally to below 1.5% yield again) and a sustained recovery in the German Dax index. Indeed, world equity markets have lifted decisively over the last week as hyperactive trading funds were caught wrong footed. In Australia, the equity market index rallied as previously unloved leading stocks suddenly found favour and the recent period of flipping the equity market index faltered.
The flipping of the index over the last four months involved a trading strategy where hedge funds and pair traders constructed their portfolios to be net short leading stocks and let long mid-cap stocks. This strategy was working beautifully in Australia because both international funds and the largest Australian based asset managers were de-weighting Australian equities in their asset allocation mix. The focus of this meant that selling pressure was focussed in the largest stocks. Meanwhile asset allocators continue to flow funds to mid-cap stocks and a pair trade is created for smart active long/short funds – short the large companies and buy the mid-caps!
However, such a crowded trade can work for only so long and it can go wrong when Central Banks create a liquidity bubble that pushes up equity indexes. The mad scramble in equity markets last week was a short covering rally and no one really knows how long it will last. In our view investors need to understand that it is like many of the rallies in recent years – it has little to do with value and has everything to do with mindless trading activity that results from historic low risk free returns.
So what should investors do?
First, they should not chase this rally as it is not the start of some “bull market” or the start of a sustained equity market recovery. For those investors who have been buying the recent dip a period of profit taking for a part of their portfolio has probably arrived.
Also, we would caution about believing that somehow mid-cap stocks are worth high multiples or indeed deserve a premium rating to large companies. We outlined above what we believe has been happening in the market. The equity flip trade may return but you would be silly to believe it is anything other than a market trade that will unwind at some point in the future.