Easing in Stock ‘Polarization’ Is a Sign That Crowded Trades Are Being Unwound

(Bloomberg) -- A model that plots valuations to tell which stocks have gotten too popular shows the excesses that preceded the meltdown have receded.

That’s according to Cirrus Research LLC, inventor of an indicator known as the polarization quotient that assesses how much investors are gravitating toward the best-performing shares. The gauge, which measures crowding, has fallen after the October rout, entering a range that’s considered safe for the market.

“We had a pretty severe breakdown in leadership stocks,” Satya Padhuman, head of research at Cirrus, said by phone. “We’re in a better ground than just six weeks ago. That’s potentially good news.”

Easing in Stock ‘Polarization’ Is a Sign That Crowded Trades Are Being Unwound

The firm’s polarization quotient tracks the relative valuation of the best-performing stocks to the market. Historically, readings of 70 percent or higher have preceded weaker returns broadly over the next six to 12 months. The gauge fell to 50 percent from 80 percent in October.

The data is one lens into investors’ psychology after darling stocks such as the internet giants bore the brunt of the latest sell-off. All year, a major bear case on equities has held that too much money had chased the same stocks, and once sentiment turned, the whole market would crater.

That seemed to happen last month. The FANG block of Facebook, Amazon, Netflix and Google’s parent Alphabet sank to a bear market decline of more than 20 percent from its July peak as third-quarter results disappointed and regulation risk grew from the U.S. to Europe. The Nasdaq 100 Index suffered its worst month since the 2008 financial crisis while the S&P 500 fell to the brink of a 10 percent correction.

“The hot stocks we love -- if they’re earning their way into their market caps, it’s fine,” Padhuman said. “But the moment their multiples become excessive, all it takes is an anecdotal adverse data point and the market will over-react to the downside.”

Data from other firms have suggested the congestion in the market has yet to ease. Goldman Sachs found its hedge fund clients dove right back to technology and consumer-discretionary, stocks they’ve favored, at the end of October.

Easing in Stock ‘Polarization’ Is a Sign That Crowded Trades Are Being Unwound

Padhuman said he wouldn’t call it all clear for the market yet because the Cirrus polarization quotient tends to be volatile. In August, the measure dipped into the neutral territory before spiking up again as traders rushed to buy the dip. Moreover, readings for small-cap stocks still showed an extreme level of crowding.

“I’ve learned to be a little patient about how it run its course,” he said. “Very quickly you can see multiples escalate because you’re still in that upper echelon and you are going to have folks looking for any pullback to go in, especially in a bullish setting,” he added. “We typical wait for a couple months to see if it settles in.”

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