One byproduct of the recent tick higher in bond yields: a meaningful rise in volatility for both stocks and bonds. This volatility uptick was evident last week, though both asset classes rebounded on Friday after the April jobs report shifted expectations for a Federal Reserve (Fed) interest rate hike.
The VIX Index — a measure of implied volatility in U.S. large-cap stocks—rose to more than 16 last week, a one-month high. While this is still below the long-term average, volatility has jumped by roughly 35% since early May. Meanwhile, the MOVE Index — a measure of bond market volatility–jumped from 70 to 90, a near 30% move in less than two weeks.
Looking forward, the Fed is still likely to hike later this fall. As we get closer to a Fed rate increase, rates are likely to rise moderately, and volatility will probably pick up. As I write in my new weekly commentary, increasing volatility has an important implication for investors: It represents a headwind for many of the most popular momentum trades.
The “momentum” trading approach — buying whatever goes up the most — has been extremely effective for most of the past several years, as a low-volatility environment tends to favor this style.
But it doesn’t take much market volatility for momentum trades to unravel. Over the last few weeks, many segments of the market that have most benefited from momentum, such as biotech and social media companies, have been the hardest hit. For example, since peaking in April, the Nasdaq Biotech Index had fallen nearly 10% at its lows, a much more severe decline than the broader market.
The loss of momentum is having a predictable impact on investor sentiment; Last week, investors withdrew more than $11 billion from U.S. large-cap equity exchange traded funds, according to BlackRock fund flow data.
As volatility is still below the long-term average, and we are still in the early stages of the market adjusting to a more normal interest rate regime, the slowing momentum seems likely to continue.
This suggests investors are starting to reduce their exposure to momentum strategies and may want to consider more value-oriented parts of the equity market. One such value-oriented area: integrated oil companies. Despite rallying roughly 5% from the recent lows, large integrated energy companies still trade at a nearly 40% discount to the S&P 500 (based on price-to-book), the largest such discount going back to at least 1995.
Sources: Bloomberg, BlackRock
Russ Koesterich, CFA, is the Global Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog and you can find more of his posts here.