EHLS: Market Turmoil Continues
- sam00070
- Apr 3
- 7 min read
Extreme Sector Rotation Observed
In This Update
Enhanced Clustering:Our revised clustering methodology, briefly mentioned last month, has significantly improved portfolio exposure visibility.
Equity Exposure Reduced:Net equity exposure was reduced over March from an initial 60.6% to 48.7% by month-end during increased turnover to better align exposures.
Dynamic Sector Allocation:Financials and Utilities remain the fund’s largest sector overweights with Consumer Cyclicals as the only negative weighting.
China and AI:The domestic AI-theme trade has weakened, though we continue to monitor for future re-engagement and still hold China-related exposures, which we believe the country is trying to position itself as the AI-processor of the world much like it did with manufacturing.
Looking Back
The markets have continued to face downside pressure—extremely calm and orderly, yet consistent and swift. According to Fundstrat, this drawdown for the S&P 500 was the fifth fastest ten percent decline from highs since 1950. While our fund still outperforms the S&P 500 since the previous August lows, our attention has focused on refining our clustering methodologies as discussed in our last update.
By improving our clustering methods, we now have better visibility into our exposures, particularly in aligning our longs and shorts to more appropriately offset each other and dampen volatility compared to what has previously been experienced. At Even Herd, we do not believe in "pair trading" or hedging well-performing investments solely for risk management. Instead, we look to long strong performers and short the laggards. We believe this approach yields significant upside participation while dampening drawdown risks over the long term. However, in the shorter term, portfolio disconnects can occur due to long and short imbalances during severe rotations, similar to what we observed over the last several weeks.
To mitigate these risks, we adhere to stringent diversification not only across position sizing but also among industry exposures. While we monitor correlations, our system most closely resembles relative momentum-based strategies, where longs tend to correlate highly with each other and inversely with shorts. Consequently, we've focused our clustering efforts on how positions behave within our internal system. This represents not a change in the system itself, but rather an additional portfolio management tool to assist in better investment selection, illuminating exposures between longs and shorts and identifying potential behavioral misalignments that some strategies may experience during periods of high correlation.
Through our revised clustering approach, we discovered that approximately 15% of our clusters constituted roughly half of all net equity exposure. While we're comfortable being overweight in certain areas, this led to a much larger swing than desired, given the fund's focus on being a core equity strategy. The market punished high-growth or beta-sensitive areas, which is common in market corrections. We had been discussing the "tightness" of sectors, and we finally witnessed breakouts favoring a more conservative stance, with sectors like Utilities pulling ahead of the pack. The rotation has not yet been viewed as too severe due to the outperformance in these areas for several months prior to the correction. Stocks like Robinhood (HOOD), which had risen 75% this year as of mid-February, faltered nearly 45% in less than a month.
Additionally, we previously discussed the AI-theme trade, which has suffered damage. The fund was gradually rotating out of these exposures, though some still remain. We initially viewed this as a shift to Chinese players like GDS Holdings (GDS); however, these stocks have now relinquished much of their year's gains as well. We've also observed certain positions, such as Modine Manufacturing (MOD), transitioning from a long to a short. Conceptually, we continue to believe that Artificial Intelligence will significantly impact and disrupt nearly every industry. However, for investments, we'll continue to follow our system's guidance, hoping to regain exposure to this theme in the future. We continue to view China as trying to position themselves as the AI-data processor of the world, much in the way the country set itself up to be the world’s manufacturer for the last few decades, now shifting its focus to the digital realm where unceomprehensible amounts of data will be processed and China's cost advantage is light years ahead.
After revising our clusters, we identified several pockets with only shorts and no offsetting longs—less ideal from a portfolio management perspective. While this concerns us less on a longer-term basis, we believe it exposes the fund to movements witnessed during recent declines where specific market segments suffer disproportionately. We significantly increased turnover this month to better align these exposures and readjust sector overweights that have shifted since February. We continue to focus on balancing exposures by removing longs in overstretched areas or adding shorts to offset exposure. Additionally, we looked to close shorts with negative exposures or add longs to better balance the fund's exposure to these clusters.
Throughout the month, we maintained Financials and Utilities overweight while reducing our net equity exposure to 48.7% by month-end from 60.6% in February. We also decreased position counts from 394 to 310 while substantially diversifying our internal cluster exposures. We should note that among all our simulations exploring how we could have performed better—even targeting zero net equity exposure—our system holdings would still have experienced a drawdown from the market peak on February 19th. We believe much of this stems from our exposure to the momentum factor, which appeared to be most severely impacted as successful investments took a dramatic, swift turn and correlations seemed to converge.
Looking Forward
With enhanced visibility into portfolio exposures, we anticipate being able to maintain lower net equity exposure during the current market turbulence. In the immediate term, we will use this tool to illuminate exposures and ensure better alignment between our longs and shorts. Current rotations most closely resemble those of 2022, though occurring at much greater speeds. We will continue to maintain overweights in specific areas as warranted by our system. For example, Argentina has been an area of focus for over two years. The "worst" stock with similar exposures still ranks in the top 15% of securities analyzed by our system, leaving us without meaningful positions to reduce long exposure. We closely monitor these positions to prevent drift. However, this area has underperformed through the first quarter with positions like Banco Macro (BMA) and YPF (YPF), which we continue to evaluate. At the time of writing, these positions remain among the top-performing areas of the system.
Financials continue to demonstrate relative strength and remain our largest sector overweight. We anticipate this will persist through the month, along with a new overweight to Utilities. Consumer Defensive and Real Estate appear strong, and we intend to maintain these exposures, although their lead is less pronounced than the top two sectors. Cyclicals declined sharply in March, allowing us to underweight the sector during our cluster recalibration; it is currently the only sector with negative net exposure. Healthcare and Basic Materials also continue to underperform, but most centrally ranked sectors remain quite crowded and could fluctuate through April. Gold miners have seen renewed strength, and the fund currently holds two larger positions with exposure to this space: Alamos Gold (AGI) and Agnico Eagle Mines (AEM).
Trade Wars
We would be remiss not to mention the ongoing trade wars. Although they do not directly impact our decisions, we monitor our system for information related to various scenarios or concepts to which we may want to adjust exposure based on the system's guidance. Currently, we believe the market continues to assess whether the US will enter a recession this year. We consider this technically possible when factoring in the severe spending cuts promised and the reduction in the federal workforce. The tariffs could drain more near-term liquidity, causing increased market volatility, not to mention the abrupt changes in daily headlines.
While initially viewed as a negotiation tactic, tariffs now appear to be a tool this administration intends to maintain permanently. We currently conclude that these apparently hasty decisions aim to compel affected businesses to seek solutions sooner rather than waiting for the next election cycle. We believe our new clustering enhancements will help insulate portfolios from volatility during these trade negotiations that are likely to sustain elevated market turmoil.
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