(Bloomberg) -- To the casual observer, the backdrop to this year’s record-breaking stock rally has been one of epic calm in markets. To Wall Street’s math wizards, it’s been anything but.

Quantitative traders who pick stocks based on rules like how cheap or how stable they appear — known as factors — are getting lashed by some of the most violent swings in years, as investors grapple with a US economy that continues to expand in the era of elevated interest rates. 

While broad gauges of turbulence for equity benchmarks sit below their long-term average, the 60-day volatility of a strategy that buys small-capitalization stocks has surged near the highest in three years. A trade that bids up companies with strong balance sheets and reliable profits, known as quality, is the rockiest since early 2021. Even an investing approach that favors steady stocks is the least steady in a year, market-neutral Dow Jones indexes show.

The volatility beneath the surface of rallying indexes is sending a message for both systematic traders and their discretionary peers: A risk-on rotation may be afoot as strategies sensitive to the US business cycle start to enjoy a spirited rally. 

It’s early days yet. But any oncoming shift in investment preferences threatens the powerful dominance of a handful of Big Tech companies like Nvidia Corp., which is due to report earnings at the Wednesday market close. It would also prove a boon for little-loved factors this year known as size and value, while popular trades like growth and momentum would falter.

“There’s an element of exhaustion of chasing those very high valuations,” said Amadeo Alentorn, the lead manager of the $2 billion Jupiter Merian Global Equity Absolute Return Fund, who has shifted positioning to favor value shares in recent weeks. “There are names that are high-quality, maybe are not as glamorous and sexy as some of these tech names, but they offer much better value at this point.” 

All told, the start of 2024 has been broadly positive for many systematic stock investors despite the rising factor volatility. Equity quants overall have posted a 6.6% return so far this year, making them the best performers among hedge-fund strategies tracked by PivotalPath. The AQR Equity Market Neutral Fund, a bellwether of multi-factor portfolios, is up 5.1%.

Among the typical strategies they pursue, quality, low volatility and momentum have all scored big gains, as companies with low leverage and strong earnings — including the tech mega-caps — have soared to new heights. Yet alongside increased volatility heralding a potential rotation, there are signs that market trends are becoming stretched, which risks derailing winning trades. 

Quality shares, for example, are near the priciest ever versus the broader market in data going back to 2013, MSCI indexes show. Concentration across the American stock market is almost as high as in 2000 and 1929, according to Deutsche Bank AG, driven by gains in the so-called Magnificent Seven cohort. 

Hedge funds’ long portfolios are now as exposed to the momentum factor — which involves buying equities with recent price gains — than ever before, data from Goldman Sachs show.

“The exceptional current degrees of hedge fund crowding, momentum exposure, and gross leverage have all benefited returns during the past year,” wrote a Goldman team led by Ben Snider. “However, these also point to the risk of a violent unwind if the market environment shifts.”

Read more: Hedge Funds Cut Magnificent Seven in Last Quarter, Goldman Says

Morgan Stanley quants have also issued a warning about the continued outperformance in the momentum strategy. The factor, whose largest exposure is software, has been “very expensive” and trading in tandem with so-called growth shares, according to a team led by Ronald Ho. The worry is that elevated interest rates could sap investor willingness to pay lofty prices for such companies, whose best profits are often expected in years to come.

In a sign of the rapid factor gyrations, last week saw three separate sessions where small caps underperformed or outperformed at 99th-percentile margin, meaning that the swings were larger than 99% of those recorded in history, according to data from 22V Research.

To strategists at the firm, it’s an optimum moment to position for a risk-on rotation — especially if the economy continues to power ahead and inflationary pressures get snuffed out.

“Now is a good time to re-engage on pressing long risk-on factors, value, and the average stock versus the S&P 100,” wrote a team led by Dennis DeBusschere. “Valuation spreads are still wide.”

--With assistance from Abhishek Vishnoi.

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