We Trade Factors, Not Stocks

Most traders spend too much time on market direction.

They try hard to formulate an opinion about an outcome where the odds of success are no more than a coin flip.

When talking about markets, it’s a favorite topic yet the shallowest. It’s like living in a 3D world but looking at things from just one perspective.

The market has multiple dimensions. They’re called factors.

Institutional-level traders and investors already know this. People don’t really trade stocks, rates, or commodities. We trade these factors.

We’ll buy a basket of “value”… short some “growth”… and wrap it around with an interest rate hedge.

These factors affect each other from a distance. Take a look at two of the most popular ones, growth and value.

Growth scores stocks based on descriptors like historical sales, earnings growth, and analyst predictions. There are many ways to define it, but they all essentially tell you the same thing.

Value, on the other hand, ranks stocks using metrics like price to earnings (P/E) and book value.

The thing to notice is when one spins left, the other spins right.

But they always meet in the middle.

That’s why factors are much more predictable than stocks. They have better reversion qualities when placed against each other.

These factors are made up of groups of stocks, and there are various ways to look at them. As a trader, my preferred method is to look at it from a long/short basis.

I’m trying to answer: “What is the effect of buying the top 20 stocks and shorting the bottom 20 when ranked by growth?” (I can swap out growth with “value” or even “momentum” too.)

I want to know what strategy I should use next.

The chart above is a multi-year view, just to show how entangled these factors can be. But it gets more interesting when you zoom in on shorter time periods.

You could see growth vs. value dancing around each other up until Silicon Valley Bank (SIVB) collapsed in March. Then the trend visibly changed when they crossed over.

The growth factor took over in the market.

Here are the returns this year of the highest-ranked growth stocks (as defined above):

TSLA: Up 110%

AMZN: Up 54%

NVDA: Up 205%

AAPL: Up 47%

NFLX: Up 46%

MSFT: Up 36%

These names should ring a bell. They also comprise 35% of the Invesco QQQ Trust Series 1 (QQQ). So it’s no wonder why the index is up 40% year-to-date (YTD). Growth has dominated.

But we’re not in the business of looking to the past. Our job is to look toward the future. The dynamics between these factors change, as do investor preferences.

And stocks can exist within different factors at the same time as well.

Take NVDA, for example. It’s part of the growth factor, but also ranks fourth in “3-month earnings per share (EPS) revisions.” This factor ranks the top stocks according to how much their earnings estimates have gone up over the last three months.

And here’s a chart of that factor relative to growth and value.

This view reveals something very interesting – and something that should make the market very, very fearful.

One, value is making a big comeback.

But here’s the bigger insight: three-month revisions as a factor are leading the weakness in stocks.

When that starts to underperform, it means a lot of good news is priced in.

And NVDA tops that list.

Analysts are projecting higher and higher EPS – typically an outperforming factor – but there are no more new buyers left.

This is why on June 23, we called for the large-cap tech to start underperforming value: “The time-tested principles of buying low and selling high will make large-cap tech a laggard in the second half relative to the S&P 500.”

But from a macro point of view, there’s something more ominous to glean from trading factors.

The top stocks on the list are peppered with real estate stocks. That should make the market think twice about its dismissal of turbulence ahead.

Real estate is still a wild card for the economy. The effect of underperforming assets still on bank balance sheets related to commercial real estate is still unknown.

Yet the Fed keeps raising rates.

Since then, Real Estate Select Sector SPDR Fund (XLRE) is down 2.67% while SPDR S&P Regional Banking ETF (KRE) is up 14.5%.

That’s a factor divergence if I’ve ever seen one.

Regards,

Eric Shamilov
Analyst, Trading With Larry Benedict

P.S. I know it’s out there. I see the bears rubbing their paws in anticipation. But in case you were wondering, no one cares about Fitch.

Or any credit rating agency.

Even when S&P downgraded the U.S. for the first time in 2011, the market made up those losses in five days. There are tons of valid reasons to be bearish, just not because of Fitch.