It’s no secret that in a perplexing reversal of his traditional skepticism (one which likely involved a tap on the shoulder or two as part of his recent promotion), JPM’s head quant Marko Kolanovic turned decidedly bullish this year (going so far as to blame a recent selloff not on fundamental reasons but a “severe snowstorm“), and predicting a favorable outcome at every opportunity.
Today was no different, and in his later commentary on “markets and volatility” while still bullish, Kolanovic observed that things haven’t turned out quite as expected, with the S&P down 1.5% YTD despite the strongest earnings season since 2011. So whose fault is it now that reality refuses to comply with the quant “wizard’s” predictions? Apparently, it’s the “upside down” market that is to blame, to wit:
Equity up and volatility up would not be the only “upside down” market pattern this year. Many established patterns at least partially reversed:
- bond-equity correlation (something we warned about),
- strong earnings were often sold and poor earnings rallied (position de-risking and covering of shorts),
- correlation and volatility spiked during earnings seasons,
- defensive sectors outperformed on the upside and value outperformed on the downside, and so on.
Many of these are a result of the transition from monetary to fiscal stimulus in the US, deleveraging of convex strategies (such as volatility selling, targeting), and rotations out of crowded positions in bond proxy and growth segments (we underweight bond proxies and tech last year).
And while so far the “upside down” market has wreaked havoc on expert predictions, Kolanvic is hopeful that a “Constanza market” should eventually help him – and other bulls – out (emphasis on the word “hopeful”).
In this (so far, chaotic) year – we also witnessed significant US equity fund outflows during the period supposed to be the strongest seasonal part of the year. If the “upside down” market patterns continue, the “sell in May and go away” prescription (that reflects a reversion of inflows early in the year) may turn into “buy in May” this year.
Actually, those hoping this is the case, may want to curb your enthusiasm there, because the the “abnormal market” has already struck here, and as Ryak Detrick reminds us, the S&P 500 has been higher in May each of the past 5 years. As such a real “upside down” market would be one which goes back to normal, and suffers a steep plunge in the coming months.
Before we get carried away with ‘Sell in May and Go Away’, just remember that the S&P 500 has been higher in May each of the past 5 years.
— Ryan Detrick, CMT (@RyanDetrick) April 29, 2018
What else? Well there is Kolanovic’s hope that systematic investors will step in and start buying:
Systematic investors thoroughly de-risked by selling ~$300bn of equities this year. If volatility can stay contained and the market can make modest gains, systematic investors would re-risk. For instance, three-month price momentum is more likely to turn positive in early May (three months since the February crash), which could result in buying of up to ~$50bn by trend followers. Volatility-sensitive investors would be slower to re-risk at ~$10bn per week, but this could accelerate if volatility declines more substantially. In addition, buybacks are expected to pick up activity after individual companies announce earnings, and may add up to ~$20bn of inflows per week at its peak.
There is just one problem with this theory too, because as Morgan Stanley reported yesterday, there is nobody left to buy stocks, something we have seen for much of earnings season when companies reported earnings only to tumble as marginal holders sold instead of bought. To wit:
Very simply HFs remain very crowded in the same positions (i.e. Tech) and there are fewer marginal buyers left. The MS PB Content team has noted that HF gross exposures remain elevated, and from conversations with investors this positioning was driven by optimism over 1Q data.
And some more details from Morgan Stanley’s own competing, and far more skeptical than its JPM peers, quant team:
- Retail has been selling (passive funds saw the biggest outflows since 2009 over the last 3 months, see charts below) and likely remain on the sidelines due to the increase in volatility
- Likewise systematic investors are unlikely about to buy too strongly as volatility remains elevated
- HFs have hung on to their positions over the last few months as they have benefited from a positive ‘performance cushion’ with the average fund up 1 to 2% YTD per the MS PB Content team. But recent returns of the MS Momentum baskets suggests performance is struggling (MSZZMOMO for fundamental-like sector-biased / MS00MOMO for quant-like sector neutral – see chart below). And MS Equity Strategist Mike Wilson has written about the lack of leadership in US equities (see Leadership in Transition; Buy Energy and Fins; Sell Semis and Retail, April 23 2018) which could challenge consensus positions further (see chart below).
- Corporates will start to re-enter the market as earnings season draws to a close, but these flows argue more for less downside than explosive upside as buybacks are a drip not a flood
- Asset managers and more macro-focused investors could provide some demand but their flows have been choppy (selling in Feb and March has turned to very modest buying in the last week) and they remain a wild card
So with the quasi mea culpa out of the way, what happens next? Here Kolanovic reverts back to recently, and strangely, permabullish self, and writes that the 5 key sources of risk…
- reduction of monetary accommodation in the US;
- high equity positioning particularly in systematic strategies;
- unsustainably low level of market volatility last year, and
- elevated valuations in sectors such as low volatility and growth.
- liquidity and liquidity disruptions may be a hallmark of the next market crisis. Where do we stand with these risks?
…are now “lower than they were when we highlighted them at the end of last year”, and explains:
Positioning was reduced (e.g. volatility targeting strategies are likely near the lows of equity allocation, retail holding of short volatility assets were decimated), and volatility reset higher, thus reducing the risk of a sudden shock and
deleveraging. Equity valuations came down substantially given the record increase of earnings. For instance, S&P 500 next 12-month P/E currently at ~16x is slightly below both the historical average and median, which is by definition is not expensive (note that using old tax rates in estimating valuation, i.e. using trailing earnings, is not relevant). While most of these risks declined, a new risk emerged in March related to policies from the US administration.
Kolanovic concludes by focusing on some of the biggest remaining risk overhangs, including central banks, liquidity and political risks, all of which as presented in a “alleged fact-spin” pair, to wit:
Central Bank Balance Sheet Risk: Likely Overstated
Investors have recently been worried about the Fed’s balance sheet reduction and its imminent impact on equities. The premise is that required demand for bonds will come at the expense of equity allocations. By the end of this year, the Fed’s balance sheet is expected to contract by ~$325bn. We first note that the ECB and BOJ balance sheets are expected to increase by ~$525bn over the same time period, and that speculators already amassed ~$170bn of short bond futures positions. So a meaningful demand may come from carry trades and covering of speculative shorts. Second, we note that some of the downward price adjustment in equities already happened in relation to the rates shock (namely ~$200bn of equity selling from volatility and rate-equity sensitive funds). If there is a residual imbalance in bond-equity flows, it is likely to be absorbed by other equity inflows (for example, just one S&P 500 company, AAPL, is expected to add ~$200bn of buybacks).
Spin: “If balance sheet contraction fears are behind the recent selloff, then the pullback is largely exaggerated: a ~10% pullback in equities (and 5% pullback in bonds) would imply that the market already priced-in half of the G4 balance sheet being unwound, while in fact, G4 balance sheets are still expanding in aggregate. A potential policy mistake by the Fed is still one of the largest risks facing the economy long-term, but we think that in the near/medium term, risk of Fed-induced recession is relatively low.”
Liquidity: Risks of Market “Uberization”
We have noted in the past that a combination of computerized sellers, and computerized market makers poses a threat to equity price stability. As volatility increases, systematic investors have to sell, and at the same time market depth as provided by electronic market makers quickly disappears. For instance, S&P 500 futures market depth dropped over 90% during the February selloff. What is the reason for such a dramatic drop in liquidity? The most important driver is likely the increase of volatility (e.g. VIX), given that many market making algos (as well as business models) were calibrated during the years of low volatility. As these programs don’t have an obligation to make markets and are optimized for profits, they likely adjust quotes and reduce size in order to maximize their own Sharpe ratio. Other factors likely played a role as well: the increase in short-term rates (e.g. LIBOR), increase of exchange margin requirements, index fund outflows, and risk capital being diverted towards cryptocurrency market making. Full electronification of the market making industry has never been tested in a recession environment. Given that financial markets are a critical part of the economy’s infrastructure, perhaps more attention should be paid to the risks posed by the Uberization of financial markets. The analogy between market making and Uberization is as follows: when there are normal market conditions, the amount of liquidity (cars available) is more than needed and market transaction costs (fare) is low, thus benefiting market participants. However, when there is a volatility shock (heavy traffic, weather) liquidity quickly disappears (i.e. fares can surge to unreasonable levels.
Spin: “Human market makers (the analogy of regulated taxi services or public transport) were to a large extent dismantled over the past decade, so there is hardly any alternative liquidity back-up. These risks previously manifested themselves as ‘flash crashes’ in single stocks and indices. However, equally damaging for investor confidence are what we see now as ‘slow moving crashes’ that can last several hours as was the case recently with some large stocks and market segments (e.g. Caterpillar ~11% intraday drop on April 24th).”
Political Risks: Is the worst behind us?
The market sell-off in February was almost entirely driven by de-risking of systematic strategies at a time when futures liquidity collapsed. As such we called for a rebound and quick price reversion. After the Nasdaq reached new all-time highs, the worst of the technical impact was behind us and it looked like the best of fundamentals was still ahead of us (earnings season and the full impact of tax reform). Then came the flurry of market destabilizing headlines related to the US administration. In a short period of time, there were announcements related to Steel and Aluminum tariffs, NAFTA, a trade war with China, intervention in Syria and prospects of further escalation, Amazon and Facebook, Rusal sanctions, the Iran deal, etc. These headlines (often tweets) dealt a blow to the confidence of US markets and businesses. For instance, when it comes to trade, damage (as measured by the market capitalization erased) was likely 1-2 orders of magnitude higher than the value of the tariffs themselves. The administration that was perceived as pro-business and a tailwind for markets since the end of 2016 started being perceived by many investors as a headwind and a source of risk.
Spin: “We think that these risks are likely to moderate and that the worst is behind us. While still a destabilizing factor, risks can be walked back by the administration or undone by new deals. On the other hand, positives such as tax reform will stay, and cannot be undone regardless of e.g. the outcome of mid-term elections and related political changes.”
* * *
So to summarize Kolanovic, ignore the “upside down” market which has refused to comply with all bullish predictions so far, and instead focus on the spin to the three major outstanding risk factors. Ok, fine, at some point “Gandalf” will be right, or maybe he has truly lost his touch and is on his way to becoming another Gartman. The jury is still out, although we should have an relatively clear answer in the next few months.
As for the traders, perhaps the best course of action is to just ignore what experts are predicting, not just Marko but all his peers, and instead just keep doing the opposite of what Gartman predicts: so far this year, that particular strategy has had a 92% hit rate, making Gartman the single most important “factor” in the stock market.
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