Barclays: Quant Funds Now Prop Up Stocks as Oil Holds the Key

Quant funds have become the stock market's main source of support as investor momentum fades, and any year-end rally now hinges on oil prices coming down, according to Barclays.

A team at the London-headquartered bank, led by Emmanuel Cau, head of European equity strategy, laid out the picture in a Wednesday note. Appetite on Wall Street is deteriorating. Retail sentiment has turned its most bearish so far this year. Yet systematic funds — portfolios run by computers executing predefined algorithms — have pushed their exposure to stocks close to peak levels.

That concentration cuts both ways. Stock prices generally decline in September, but the final quarter is historically the best-performing stretch of the year, and the upcoming midterm elections should also lend support, the strategists wrote.

The bigger swing factor is crude. "Although FOMO remains palpable, erratic price action suggests a lack of conviction," the Barclays team wrote. "This time indeed, a year-end rally and renewed rotation into Europe likely require lower/stable oil prices, which is anyone's guess."

The bond market, in particular, appears to be pricing in oil staying elevated for longer. The yield on the 30-year U.S. Treasury TMUBMUSD30Y hit a 24-year high of 5.617% on Tuesday, while the 10-year's TMUBMUSD10Y yield climbed to 5.229%, close to its 19-year peak. A peace deal between the U.S. and Iran would help lift both stocks and bonds, the strategists said.

The flow data underscores how thin the market's footing has become. U.S. equity inflows have slowed, with outflows recorded in four of the previous five weeks, according to Barclays. European inflows have also eased, as hedge funds exited their long positions when oil prices spiked.

Positioning has grown lopsided at the same time. September brought narrowing market breadth, with funds heavily exposed to the semiconductor, capital goods, utility and materials sectors, while software, healthcare, luxury and other defensive stocks remained under-owned, the strategists said.

Energy itself has drawn little fresh money despite higher oil prices. "Energy flows have picked up only marginally despite higher oil prices," they wrote. "But if oil and rates ease, capex leadership could re-emerge and consumer stocks may be due for a tactical catch-up."

The upshot: with humans pulling back and algorithms near maximum exposure, the fourth quarter's traditional strength depends heavily on crude cooperating — or on a geopolitical breakthrough that brings energy costs down.