The following is an excerpt from our recently published SWS Growth Equity 3Q2021 strategy update. For a copy of the complete document, please contact us. In the full piece, we provide our take on sifting through an increasingly volatile equity market backdrop, while assessing the strategic merits of our internally managed strategy for public growth-style equity.
Our read of the current fundamental signals continues to support that 2021 will be a grind-out period for active return generation. This in large part is due to a global macro dislocation that caused the most dramatic acceleration of digital transformations across all industries. The market is still undergoing a massive sortation of flash-in-the-pans from sustainable share-gainers as we edge closer to a post-pandemic environment. As active equity managers tasked with relative value creation, we remain optimistic on how our investment process is calibrated to generate attractive risk-adjusted outcomes in this backdrop.
Changing Composition of Market Participants
An inescapable truth of public equity: the same mechanism that marks its value is subject to dislocations caused by other participants trafficking in the underlying. This occurs regardless of the changing participant composition and their motives, and 2021 has seen its fair share of flow-related disruptions. Pinpointing their exact source can prove difficult, thanks to the anonymity of dark-pool and algorithmic trading. Timing when pricing dislocations occur also can be futile in the era of frictionless, commission-free execution via smartphone app. However, we have some artifacts to assist in sizing their presence and revealing the potential rationale behind their trading activity.
Options Tail Wags Equity Dog
Nine of the 10 most active call-option days ever in history took place in 2021. The notional value traded in single-stock equity options also surpassed the actual value traded in the underlying equity this year, for the first time ever on record. Certain issuers, like AAPL and TSLA, even saw their options’ notional value traded exceed 1.7x and 4.0x that of their underlying equity, respectively. These conditions make option expiration dates ripe for powder-keg formation, in turn creating increased equity price volatility. Equities in a sense become derivatives of their own derivative, somewhat a case of the tail wagging the dog.
China Shoe Drops Continue
Another flow-driven impact relates to geopolitical factors, the most salient this year being from China. When the Evergrande shoe-drop followed a series of earlier red flags signaling that Beijing may be retracing its steps to wade selectively into capitalism, mega-cap tech titans like Apple, Microsoft, and Alphabet take on the role of relative tech-sector safe havens when Alibaba, Tencent, Didi, and others find themselves in political crosshairs. This flight-to-safety via US-domiciled mega-caps undoubtedly created a market cap headwind for our lower relative weighted average market cap, specifically a 2,200 bps one over the Mar-Aug 2021 timeframe. We’ve covered the fundamental justifications to skewing down the market cap spectrum at this stage of economic recovery, but we see mega-caps in the $trillion club as showing signs of top-heaviness. As such, we see merit in remaining underweight market cap over the medium-term environment…
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