Why Wall Street Can Ignore a Pandemic

As money managers rushed to price in stronger economic growth, factor investors who dissect stocks by how much they’ve risen or fallen saw this strategy, known as momentum, crash on Monday like never before. Equities more sensitive to the economic cycle like value and small-cap names skyrocketed.

So while the S&P 500 is just shy of its record high, it’s been a wild week for quants even by the standards of this wild year, with many enduring violent moves rather than capitalizing on the risk-on mood.

All this recalls long-standing worries that freakish cross-asset gyrations are getting more common thanks to cheap money and investor crowding.

Quigley’s estimate for the odds of this week’s shock is in part tongue-in-cheek, based on a rule of thumb for a normal distribution of statistical data. Asset moves are not known to reliably obey this convention that says 98% of all data points occur within three standard deviations of the mean.

But even with the knowledge that market prices are more prone to outlier moves, a rotation of the magnitude seen this week was still a shock to risk models.

Quigley’s small- and mid-cap strategy posted an eight-standard deviation drawdown compared with its forecast tracking error, he wrote in a letter to clients. Its large-cap portfolio, a three-standard deviation one.

This is a problem because quants decide how much market exposure to take by using historic data to calculate the odds of a fund’s positions imploding. If the distribution of price moves has changed from the past, history may no longer be a reliable guide to the present.

A rotation isn’t always a bad thing for active managers, but this week’s was so extreme that few investors were positioned for it. As a result hedge funds’ alpha, or excess returns, fell the most since March on Monday, and systematic funds suffered even more, Goldman Sachs’s prime brokerage data show.

By Wednesday momentum was rebounding, jumping the most since June to underscore just how volatile factors have become. Meanwhile, post-election relief may be helping the Cboe Volatility Index retreat, but that doesn’t mean it’s all smooth sailing for the benchmark.

Monday’s vaccine-powered rally meant the S&P 500 broke out of the trading range expected by the options market for the third week in a row. Since options are used to anticipate and protect from moves, that’s another sign of just how big the shocks have been.

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