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Have the leaders of the pack suddenly become the laggards?

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      By Edward J. Perkin, CFAChief Equity Investment Officer, Eaton Vance Management

      Boston - Even for equity investors like us - who pride ourselves on being fundamentally-based, bottom-up stock pickers - it's been hard to ignore the impact that quantitative factors can have on the market. One factor we've been watching is momentum, which is a term quants use when the leaders keep moving ahead of the pack, while the laggards keep falling behind.

      Crowded momentum trade unwinding?

      According to the MSCI factor indexes, momentum has enjoyed a long track record of outperformance relative to a broad universe of large and mid-cap US equities.1 Not surprisingly, selecting stocks for positive momentum - that is, buying the winners - became an extremely crowded trade. The magnitude and persistence of this factor's relative returns, along with evidence of significant "factor crowding" among investors, suggested to us that there might be a sharp rotation at some point.

      Sure enough, on September 9, we saw the biggest reversal of the momentum factor in more than a decade - a 4 standard deviation move!2 What worked this year and over the past 10 years suddenly stopped working. With such a dramatic unwinding of the momentum factor, value stocks - the perennial losers - have shown performance spreads as wide as 340 basis points (bps) over the quality factor and even wider at 420 bps over momentum during the last couple of days.3

      Risk of valuation reversals rising?

      Normally we would avoid focusing on such short-term returns. But we anticipate the real risk that many equity investors could be taking by running with positioning geared toward utilities, REITs and consumer staples - sectors that are perceived to be safe, yet whose valuations have risen to very rich multiples above the market.

      Meanwhile, as sentiment turned more negative, cyclicals and financials have become dirt cheap, with price to forward earnings far below the market multiple. This situation may be susceptible to a reversal. When the stampeding herd changes direction, the setback in relative factor performance can be painful.

      Bottom line: While we wait to see if this momentum unwind continues, our approach - as always - is to maintain balance and resist the urge to make big macro calls. We prefer to look for opportunities where price and fundamentals have dislocated from one another, which often leads to a positive risk/return skew. What that means now is being willing to own stocks that are still cheap, despite rebounding over the past few days. These tend to be more cyclical and economically sensitive - even exposed to China. That's a risk we think the equity market is willing to pay for in the current environment.