Resurgence of Equity L/S in 2023
Looking to witness a revival of Equity L/S, whereby fundamental bottom-up stock picking will make a strong comeback when market becomes less 'irrational' than it has been in last couple of years / and this year.
L/S alpha has been sapped due to influx of easy money and thus essentially distorted market into leveraged bet on high-beta and momentum plays.
As we go futher in tightening, market, especially single stocks complex will be more cash generation sensitive.
Anyone share the same outlook?
But at the same time, stocks have become much more correlated between each other.
A persistent unclear macro environment will push investors towards deeper analysis as they understand they cannot rely on factors as much as they did in the past. Once the growth trend will be definitely broken, investors will have to look for something else and everyone will come up with his own view until a new paradigm will be set.
Now we are still much macro driven, but once a substantial slowdown in the economy will be priced in (which is not in my opinion), we might come back to consider cycles more carefully than over recent years. Definitely a good environment for stock pickers and generalist in my view.
What exactly is "irrational" about the last couple of years? Fed injects liquidity -> market rips, Fed drains liquidity -> market tanks. Seems perfectly rational to me.
Many "real" L/S funds and particularly market-neutral have thrived during this period.
Maybe you're talking about "closet long" rather than actual L/S investing?
Oh yeah, my comment was including closet long as well. But my main point didn't change.
More specifics on my view on L/S in the past:
My view dated back to post-GFC, whereby if you stick to truly market neutral portfolios, especially during 2012-2019 where everyone saw the alpha decay challenge from that strat.
It's an area where short alpha was extremely scarce, basically fighting FED money pumping which pumped stocks. The advent of passive investing & basket trading also didn't help either because it created more flow inelasticity and drove correlation across the board. Not to mention some idiosyncratic risk from short squeeze/gamma squeeze like we saw in 2021 meme mania. Also, the amount of shops popped up and just did L/S or claimed to do L/S just made the space even more overcrowded.
The L/S funds that delivered returns during secular bull market were actually drift from market neutral and chased high beta like Tiger and ended become more of a levered tech long-only. But then the fact that they weren't market neutral and then ended up getting absolutely wacked when when bull market ended.
Now let's talk about 2022 where I see the irrationality:
Well, actually, it's equities so I always expect some irrational exuberance when it comes to stocks. I'm not talking about tech/growth valuation in past years during secular bulls, valuation is just a function of liquidity and with FED printing.
The irrational part I was mentioning and wanted to emphasize is that the market faith on the FED put, well actually that was crushed last week at Jackson Hole.
I believe market will continue to jump on the 'hopium' a few times more for the rest of the year, and FED will likely drop the hammer again, to teach them 'it's not the FED put, it's the FED short call' and they will be commited to suffocating the upside of market.
On L/S / market neutral performance this year:
Yeah been great but if you pay attention to correlation to this year, when market went through melting up and melting down, internal correlation was consistently strong, which means you don't really have to do much with a beta-neutral portfolio. Everyone talks about 'Oh market tanks correlation goes to 1, and it's bad for portfolios' but actually no, if correlation goes to 1 it's quite easy to handle, when correlation regime shifts from that to something totally different with stocks have unexpected varying degree of correlation is when things get more fascinating.
What I'm seeing for 2023:
Long alpha still remains with strong cash generative assets - well basically it's TIPS but with pricing power during stagflationary period.
But short alpha will be much more interesting, unlike this year where high beta got unwound, there will likely be less correlation to my understanding, I also expect short correlation strat like dispersion could make a comeback as well. Instead of market play like 2022, there will be more sector play and single name play.
And that's basically my humble opinion.
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You're late with that strategy, this would've been a good strategy to implement this year, not next year. FY23 should be much better vs. FY22, simply because it'll be a year of deflation and the FED will likely pause...or if inflation really drops off a cliff, we could even see our first rate cut in the 2H 23' Let's look at where we are now:
We just got November CPI @ 7.7% YoY vs. 7.9% expected, current Fed Funds Rate is ~4.50% with another guided 50bps in December making it ~5.0%. Core CPI came in today @ 6.7% vs. 7.2% expected (which is substantial.) The effects of interest rates lag by 6-12 mos. Using 6 mos. for this example, that means that CPI is only pricing in a Fed Funds rate of 0.75% (May 2022), which is remarkable.
If CPI continues dropping the way it is (unlikely) -> we'll be @ the Feds 2% target by June of next year (we could fantasize -> but it's even possible that CPI may even fall faster next year as supply chain bottlenecks easing.) The only way I see this getting worse is if China invades Taiwan or NATO ends up going to war with Russia (or both). This would be a complete disaster for markets.
What does this mean for investment strategies?
If the above comes to fruition this means - > Risk-On Rally in stocks - > Tech and Retail with dominate - > energy stocks will fall - > Industrials will fall -> Homebuilders will rise and anything 'beta neutral' will get left behind.
I've seen the narrative that 'tech is dead' before, it happens every recession. "Tech is dead, Value is back" was wrong in every recession, what ended up happening in both recessions (dotcom, GFC) is that Tech became the best performers coming out of both of them.
Here's an interesting article that I found in 2003 (Bottom of the dotcom crash):
https://www.nytimes.com/2003/12/31/business/stocks-post-sharp-gains-for-2003-breaking-their-3year-slide.html#:~:text=The%20best%20performing%20sectors%20during,economic%20turnaround%20lifted%20their%20prospects.
To quote the article:
“The best performing sectors during the year were information technology stocks, which as a group rose 46.6 percent, according to the Standard & Poor's index of 10 market sectors. Consumer discretionary stocks, including Best Buy , Sears, and Tiffany, rose 36.1 percent as the economic turnaround lifted their prospects. The worst performing sector was telecommunications services, which was up 3.3 percent as a whole. Nextel, a beaten-down technology stock, rose 142.9 percent, to $28.06. AT&T fell 22.3 percent, to $20.30.”
It's a lot more likely that we go up from here. Basically everything is priced in, the only thing that hasn't been priced in, is WW3, which is a possiblity.........
Imo was irrational because it forced people all the way to the far end of the risk curve and then forced them into right tail assumptions that would never realistically be achieved because QE cannot, in fact, accelerate indefinitely. For people who are paid on a 1yr horizon, it was certainly rational to underwrite such nonsense. But ultimately it was a gross misallocation of captial to the investors most willing to misallocate that capital to pie in the sky value-destructive enterprises.
Once all the garpy TAM-worshipping dreamers get their faces ripped off, the herd will be culled and the better funds will incorporate a larger share of AUM. But as MMPM points out, good funds have been good funds the whole time, a lot of capital accrued to momentum riders.
LOL Your know the "R" stands for "reasonable," right? There was nothing reasonable about those valuations. It was GAAP all the way.
I'm not in equities L/S, but broadly speaking I would tend to agree with you. The one caveat is that I think passive investing will continue to squash dispersion among equities, mitigating the factors you mention above to some extent.
It’s supposed to be this year…. Look at the returns. It will continue to be a good environment for pods and good neutral shops
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