- The risk-on market rally continued in July, amid several indicators of frothiness, as beta and residual volatility posted the highest factor returns in the U.S. by a wide margin and were also strong globally.
- Liquidity’s strong performance, positive performance of the stock-crowding factor and elevated crowding levels of residual volatility in the U.S. and of beta globally also pointed to froth in risky and “hot” stocks.
- In July, defensive sectors and communication services continued to under- and outperform, respectively, while technology began to fizzle out. Crowding increased in large-cap technology and communications-services stocks.
Through July 2023, the MSCI USA Index was up 21% for the year while the index’s information-technology and communication-services sectors shot up like July fireworks to 45%. This notable disparity prompted the question: Have these and other market segments gone too far too fast? In response, we reviewed factor performance through July and, using MSCI crowding models, we analyzed crowding in factors and sectors. Our analysis revealed unusually strong positive performance of risk-on factors and high levels of crowding in certain factors and sectors.
Risk-on factors were top performers in the U.S. and globally
In the month of July and year to date (YTD) through July 31, 2023, beta and residual volatility were the best-performing factors in the U.S. by a wide margin, indicating a robust risk-on market. These two factors were also strongly positive globally.1 In addition, both the liquidity — or “hot stock” — factor and the stock-crowding factor showed positive returns, the opposite of their long-term trends. The exhibit below displays the pure factor returns of the styles in the MSCI USA Equity Factor Trading Model (EFMUSATR) for the month of July and YTD July 31, 2023.
Beta and residual volatility posted the highest factor returns in the US by a wide margin
Factor returns are for the styles in the MSCI USA Equity Factor Trading Model and are ordered from left to right by YTD July 2023 performance.
MSCI crowding models signaled froth in risky and hot stocks
In a recent blog post, we observed that the recent AI-driven rally had pushed market concentration to historically high levels. In addition, the current market-leading stocks, the largest stocks, were marked by high crowding. We examined the MSCI Factor Crowding Model scores and found that residual volatility and long-term reversal crossed the threshold of +1 (standardized z-score) to become crowded in the U.S. market at the end of July. Crowding in residual volatility had remained at moderate levels since early 2022. Globally, the beta factor showed elevated crowding with a score of 1.15 at the end of July.
Long-term reversal was the best-performing value factor in the U.S. since the value rotation started in 2022 and the second-strongest style overall in EFMUSATR since January 2022. The crowding in long-term reversal at the end of July differed from other value styles — earnings yield and value — that were still mildly uncrowded. The following exhibit suggests that valuations (illustrated by the valuation spread shown in dark blue) were key drivers of the high crowding scores for both residual volatility and long-term reversal.
Valuations contributed to higher levels of crowding
A score above 1.0 is our threshold for elevated crowding. The crowding score is shown for each of the styles in the MSCI USA Equity Factor Trading Model. Data is as of July 31, 2023.
The size factor’s crowding score also caught our attention. Whereas the overall crowding score for size was unremarkable, the valuation component of the score provided a large positive contribution, indicating that large caps were more expensive than small caps to a greater degree than normal. However, the short-interest component provided a large negative contribution to the score, indicating that short sellers had already become bearish on large caps compared to small caps.
Small caps have historically outperformed larger stocks, especially after recessions. The National Bureau of Economic Research has not officially declared a recession in the U.S., but from the beginning of 2023 until the banking crisis, the MSCI USA Small Cap Index outperformed the MSCI USA Index, which includes only mid- and large-cap stocks. More recently, small caps have resumed their outperformance versus larger stocks.
Sector performance in July generally continued YTD trend
From January through July, the pro-cyclical sectors — consumer discretionary, information technology and communication services — outperformed in the U.S. and globally compared to their MSCI USA and MSCI ACWI Index benchmarks by large margins of 10-24%. In the month of July, however, as the following exhibit shows, the information-technology boom appeared to fade.
Pro-cyclical sectors outperformed the MSCI USA Index, but tech began to fade in July
Returns reported are for the MSCI USA Sector Indexes. Data is through July 31, 2023.
The exhibit below aggregates the MSCI Security Crowding Model by the Global Industry Classifciation Standard (GICS®)2 sectors as of July 31, 2023. We can see that large-cap stocks in information technology and communication services experienced the most crowding, much more so than their small-cap peers.
Large stocks in tech and communication services were among the most crowded
Crowding exposures are reported for the MSCI USA Sector Indexes. Data as of July 31, 2023.
Risk-on factor fireworks shine light on concerns that certain market segments may start to fizzle out
The risk-on factors — beta, residual volatility and liquidity — had unusually strong positive performance in the year to date through July. Elevated levels of crowding in some of those factors as well as in large-cap technology and communication-services stocks suggests a frothy U.S. market for large-cap technology and other risky stocks. Historical patterns suggest these segments may be more susceptible to drawdowns in the coming months.
1Our analysis of the global markets, which we do not show here, revealed similar results to our findings in the U.S. market.
2GICS is the global industry classification standard jointly developed by MSCI and S&P Global Market Intelligence.
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