P&C Stock Outperformance

P&C Insurance stocks have been one of the better performing areas in the market YTD, largely driven by excitement over improvements in pricing. Several names are up over 30% on the year.

When one looks a little closer at the pattern of outperformance, it becomes apparent that there is more to the story than just accelerating pricing. While most of the stock gains came after the better pricing data coincident with Q1 earnings, the outperformance actually began closer to March 1.

Why is that significant? That is when the 10 year peaked! Since then, the S&P is up just 3% while the XLF (financial sector ETF) is +1% and the KRE (bank stock ETF) is -9%.

The Role of “Rotation”

This last point is particularly telling. When investors sell bank stocks, they often look for other areas of financials to “hide” in. Nearly every P&C stock is up double digits since 3/1 with several up 20+% in that time.

Clearly, investors have rotated from bank to insurance stocks. This is a typical “safety” move during a rotation out of rate sensitive names but, with the added juice of a “pricing story”, the rotation has been heavier than normal driving the outsized P&C gains.

It is obviously difficult to ascribe how much of the outperformance is from the better fundamentals and how much is due to the rotation aspect. It is important to try to understand this dynamic if you are buying P&C stocks today, as you might be taking on interest rate risk unwittingly.

With a Fed meeting taking place this week, any change in stance by the Fed that moves the 10 year yield higher could cause a large rotation back into bank stocks. To fund these purchases, investors would likely take gains in their insurance stocks.

Since the market cap of banks dwarves that of insurers, the negative liquidity impact on P&C would cause a greater selloff than the gains in bank stocks.

While these types of rotations have been going on forever, they have become more dramatic over the past 10+ years due to the financial crisis and the growth of ETFs.

The Diminishing Importance of Fundamentals

The crisis created a demand for being able to quickly sell baskets of (somewhat) similar stocks. When there was bad news about housing, traders wanted to press a button and sell a whole lot of financials stocks at once before the market tanked (or sometimes causing it to tank).

This need was met by index funds, particularly the growth of ETF indices. The problem, in theory, with using ETFs to express a view on a theme is not all the constituents of an ETF had the same traits. To take a simple example, the XLF (the broad financials ETF) has a mix of rate sensitive and non-sensitive names. When you sell the ETF, you sell all those stocks. Again, in theory, that basis risk should hurt you because the defensive financials have better fundamentals and should trade in the opposite direction causing losses from basis risk.

However, in practice, this basis risk doesn’t matter much. When the XLF gets sold, it overwhelms most stock specific information and all the stocks go down, whether they “should” or not based on the news.

In other words, the volume of ETF being traded overwhelms the volumes being traded by fundamental investors. Taken to extremes, the disconnect between fundamentals and stock performance can last for months or even years (ask the life insurers).

In the short term, especially during market selloffs, ETF selling is pretty much the only thing that matters. If the market is down and rates are going lower, you can pretty much assure the XLF is beaten up and its individual components are being dragged down in sync, barring some pretty important company specific news.

When Stocks Become Derivatives

This is all a way of saying that, in the ETF era, stocks often don’t trade based on changes in their fundamentals. They trade on ETF and other passive flows (which are then compounded by momentum traders). In other words, stocks act as derivatives of macro events rather than the sum of their discounted cash flows.

While this may sound confusing, it’s really pretty simple. Derivatives are instruments that trade based on the change in value of another security, such as a stock or a Treasury bond. When macro traders use ETFs to express a view on trade or rates or recession risk, they are using the ETF like it’s a derivative.

This means the stocks that make up the ETF basket also trade like derivatives because these index flows make up so much of the individual stock’s volume. This can cause seemingly odd performance in individual stocks for those evaluating the company on its valuation relative to its fundamentals such as earnings.

The Risk of a Fed Driven Exodus

So what am I trying to get at here? It is important to understand these dynamics when trying to assess how much longer strong P&C performance can continue. The biggest risk is not necessarily fundamental (e.g. that the next pricing data point is worse). It’s that something causes the macro traders and the momentum buyers who don’t care (or even know about) pricing to get out for other reasons.

This brings us back to the Fed meeting this week. The Fed’s comments may change the negative sentiment on long term rates. If so, the macro traders will want to buy financials again and start buying the XLF hand over fist. This, in and of itself, would help P&C stocks as some of them are members of the XLF.

However, what is likely to happen next is, the fundamental traders will see the change in sentiment and start unwinding their long P&C vs. short banks trade. The momentum traders will then see the break in the technicals and pile on with more selling. Given the aforementioned relative lack of liquidity in insurers, we could see a substantial portion of the YTD stock gains unwind pretty quickly.

This isn’t meant to be a prediction on what the Fed will do. The meeting may be a non-event or even a catalyst for further rotation into P&C. The purpose is to create awareness that if you own P&C stocks just for the pricing story, you have a risk of being sideswiped by the Fed.