How the market’s mighty wizards have fallen.
Just last Thursday, JPM’s head quant Marko Kolanovic, the man who once moved markets with one word, predicted that the recent crash in stocks was nothing to be worried about, and that quants wouldn’t liquidate into it, to wit:
Equity price momentum is positive and trend followers are not likely to reduce equity exposure. While the recent move was concerning for its correlation properties (bonds, equities and commodities all going lower), overall the volatility of multi-asset portfolio is still very low, and the increase was relatively small (e.g., increased from ~4% to ~5%). Also, there are other circumstances that are not in favor of a continued sell-off – we are in the midst of one of the strongest earnings seasons in the US, and global growth continues to be strong.
Two trading days later, and nearly 2000 Dow points lower, that assessment could not be more wrong.
So, now that systematic funds got clearly blown up, and for countless retail investors using XIV to short volatility this may well be the end following termination events at short-vol ETFs such as XIV, Kolanovic is out with a note in which he expresses renewed hope that the cataclysmic move of the past few days – driven entirely by either CTAs, risk parity, vol-targeting funds or all of the above – is nothing but a scratch.
Here is his note:
In last week’s note, we noted that volatility, at the time, was not sufficient to trigger systematic strategy de-risking. On Friday, the market dropped ~2% on a day when bonds were down ~40bps. The move on Friday was helped by market makers’ hedging of option positions (as gamma positions turned from long to short midday). Friday’s move, on its own, was significant as it pushed realized volatility higher, which is a signal for many volatility targeting strategies to de-risk. Anecdotally, broad knowledge about the risk of systematic selling kept many investors fearful and waiting on the sidelines (both in equity and volatility markets). Midday today, short-term momentum turned negative (1M S&P 500 price return), resulting in selling from trend-following strategies.
… which, of course, is something Marko said would not happen. Anyway, back to the note:
Further outflows resulted from index option gamma hedging, covering of short volatility trades, and volatility targeting strategies. These technical flows, in the absence of fundamental buyers, resulted in a flash crash at ~3:10pm
today. At one point, the Dow was down more than 6%, and later partially recovered. After-hours, the VIX reached 38 and futures more than doubled—it is not clear at this point how this will reflect on various short volatility products (e.g., some volatility ETPs traded down over 50% after hours).
Actually, with the XIV down 80% on the day, tracking the VIX, it most likely means a termination event is imminent.
So what happens next according to the JPM head quant? In short: don’t worry, all shall be well.
Today’s large increase of market volatility will clearly contribute to further outflows from systematic strategies in the days ahead (volatility targeting, risk parity, CTAs, short volatility). The total amount of these outflows may add to ~$100bn, as things stand.
As a reminder, this is roughly half the $190 billion number cited by Goldman as the total amount in global equity selling over the next few weeks. Both numbers would be large enough to lead to further dramatic downside in the stock market.
And here comes the damage control:
However, we want to point out the massive divergence between strong market fundamentals and equity price action over the past few days. The large market decline over the past few days will likely draw fundamental investors and even trigger pension fund rebalances (those that rebalance on weight thresholds).
And if that’s not enough to wake the BTFDers out of their shocked daze, here come the big guns:
We also want to highlight a strong probability of policy makers stepping in to calm the market.
Right, because when you get a call so incredibly wrong, there is nothing quite like central banks bailling you out.
Finally, here is Kolanovic’s advice after the biggest point drop in Dow Jones history: just BTFD:
Rapid sell-offs, such as the one today, can also be followed by market bounce backs as liquidity gets exhausted by programmatic selling. With next year P/E on the S&P 500 now below 16, further positive impacts of tax reform and stabilization of bond yields (e.g., note the current record level of CFTC bond short positions), we think that the ongoing market selloff ultimately presents a buying opportunity.
On Thursday, when commenting on Kolanovic’s painfully sanguince assessment, we said that it was “Almost as if Gandalf was given the tap on the shoulder…”
We now know for sure.
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