This Is the Complacent Feel of a Mechanical Market
When the flow is mechanical, fundamentals are meaningless.
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The market had a strangely complacent feel on Monday. The action was slow and quiet through most of the day but the indices closed with respectable gains due mainly to bounces in the big-cap technology names. Breadth was slightly negative underneath the surface, which tells us the gains were concentrated in a narrow group of bigger-cap names rather than spread across the market.
The Nasdaq 100 rebalancing that hit after Monday’s close probably had an impact on the intraday action. Index funds were positioning ahead of the SpaceX (SPCX) addition that becomes effective before the open Tuesday. That is a mechanical event and has nothing to do with fundamentals. The mechanical flow can push the mega-cap names around independently of what the underlying businesses are doing.
Millennium Made $3.7 Billion on Index Rebalancing Last Month
One of the more interesting stories from Monday is the June performance at Millennium Management. Millennium is one of the largest and most successful multi-strategy hedge funds in the world. The firm manages roughly $75 billion in assets.
Like most large hedge funds, it has “pods” which operate independently. Bloomberg reported on Monday morning that two pods run by Glen Scheinberg and Pratik Madhvani made about $3.7 billion in total last month. That is more than half of the roughly $6.6 billion in profit Millennium generated before fees in June.
These two pods specialize in index rebalancing trades. Their strategy is to take highly leveraged bets on which securities will enter or exit various indexes. This is not fundamental investing. It is not stock picking. It is engineering profits from the mechanical flows created when index funds have to buy or sell specific names to match new index compositions.
Five events in June created a particularly rich environment for this kind of trading. The S&P 500 had its quarterly rebalancing. The Nasdaq 100 had its quarterly changes on Monday. The Russell indexes had their annual reconstitution. SpaceX got its fast-track inclusion. And quarter-end multi-asset rebalancing added to the mechanical flow.
Five large mechanical events in a single month produced $3.7 billion in profits for two guys running a highly leveraged strategy that has nothing to do with what any of the underlying companies are actually doing.
That is the environment we are trading in right now. A significant part of the daily price action is being driven by mechanical flow rather than fundamentals. When the index rebalancing pods at Millennium make more money than most successful hedge funds do in a decade, the disconnect between price action and business reality is impacting the trading opportunities we are seeing.
When there is a lot of mechanical action like this, near-term price action is often noise. The names that get pushed around by mechanical flow are not necessarily the names that are doing well or poorly as businesses. That is why the framework of using the system of reactions which I discussed in my weekend column is so important. When the flow is mechanical, the fundamentals are meaningless.
Strategy
My defensive posture stays in place. High cash levels and selective stock picking with a focus on the rotation winners and names with their own catalysts. I am not chasing Monday’s tech bounce.
The environment continues to reward patience and stock picking over chasing index moves. The Millennium story is a good reminder that the daily action often has more to do with mechanical flow than with the underlying businesses. Stay focused on the names with strong setups and independent catalysts rather than trying to time the mechanical moves.
Have a good evening. I’ll see you tomorrow.
At the time of publication, DePorre had no positions in any securities mentioned.
