He doesn’t have a long, white beard. He doesn’t wear a robe or a pointy hat. And he doesn’t walk with a gnarled, magic staff.
But that doesn’t stop us from characterizing JPMorgan’s resident quant wizard Marko Kolanovic as a kind of Gandalf figure.
Regular readers know Kolanovic. His star has risen over the past couple of years as market participants have started asking questions about the extent to which systematic strat deleveraging during periods of rising volatility might be contributing to large drawdowns.
To extend the Gandalf analogy, Kolanovic likes to point his light-emitting research scepter at a corner of the market that most investors don’t typically think a whole lot about.
Needless to say, quants would rather he just shut the f*ck right on up.
Consider this from a Bloomberg piece that ran in early January:
Don’t listen to Marko Kolanovic.
Or anybody else who tells you quant managers regularly whip up bouts of pain and suffering for stock investors. Funds with programs that follow trends and sell like robots are getting smaller and simply aren’t big enough to overwhelm the $24 trillion U.S. equity market.
That view comes courtesy of AQR Capital Management which, it should be noted, is far from an unbiased observer, given the $172 billion investment house pioneered many of the strategies coming up for vilification. AQR’s quants say they’ve had it after listening to more than a year’s worth of hectoring from analysts who blame managed futures and risk-parity strategies for everything from August 2015’s China meltdown to the post-Brexit plunge.
“The analysis is inaccurate,” said Brian Hurst, a principal and portfolio manager for AQR’s managed futures and risk-parity strategies. “They are using oversimplified models with bad inputs.”
Whatever. If nothing else, Kolanovic’s work is interesting. And even if something like a few hundred billion in outflows here or there from vol targeting strategies that get caught wrong footed after levering up in a low vol environment isn’t enough to trigger an outright market meltdown, we can learn a lot from reading Marko’s stuff.
Kolanovic’s latest looks at plunging stock and sector correlations (something I and others, including Goldman have discussed ad nauseam of late) and the effect low correlation has had on keeping volatility at bay. Of course suppressed volatility allows the strats Kolanovic focuses on to lever up which in turn increases the risk they pose should vol suddenly snap back.
I have to admit that I’m biased in favor of Marko’s view of the world. And not just because I happen to agree with his narrative regarding how changes in market structure make us all more vulnerable. Earlier this month, Kolanovic endeared himself to Heisenberg further with the following quote:
Various quantitative and qualitative metrics indicate that markets have become more macro driven and react faster to the new information. A qualitative example shows the reaction time for recent major events (August ’15 selloff, Brexit, US Election, Italy Referendum) that has compressed from weeks to hours. Quantitatively, we are noticing a higher density of market turning points. The average variability of asset trends (averaged across major asset classes) that show turning points occurring at the fastest pace in recent history (~30 years). Given the engagement of central banks with markets and geopolitical developments, it should not be a surprise that markets are more macro driven.
That’s basically the Heisenberg raison d’être from a quant perspective.
In his most recent note, Marko again weighs in on politics, ascribing the populist upheaval in France, the Netherlands, Britain, and Germany to the usual suspects: euro-skepticism and immigration concerns.
You’ll also note that Kolanovic flags the rather amusing fact that a reconstituted Fed under Trump could well end up favoring more accommodation and a weaker dollar. How many times have I broached that subject in these pages? There’s something terribly ironic about Trump and Peter Navarro’s weak dollar rhetoric given Trump’s previous criticism of the Yellen Fed. That is, this is very same guy who not six months ago blamed Yellen for “doing political things” by keeping rates too low. Now he’s worried rate hikes will torpedo his weak dollar rhetoric by bolstering rate differentials in favor of a stronger greenback.
Below, find Kolanovic’s latest. As always, note the highlighted passages.
Last September, we forecasted a short term increase of market volatility and equity outflows. At the time, volatility was unsustainably low, and we pointed to catalysts that would trigger de-risking by systematic investors. A similar set-up is developing now, this time driven by extremely low levels of market correlations. One of the main drivers of the recent collapse of volatility (and hence high leverage of systematic and fundamental investors) is the record decline in market correlations. Not just that the sector, stock, and country correlations are at all-time lows (figure below), but the recent change (drop) is the largest on record.
What has led to this decline in correlation? Is this a sign of more calm, fundamentally driven markets ahead or just a temporary dislocation? We think the collapse of correlations is temporary, and was driven by violent re-pricing of market segments in relationship to recent macro developments. These were primarily sector and style rotations at the back of Trump’s election and prospect of higher rates (e.g. think of Banks vs. Utilities). In addition, strong seasonal effects temporarily pushed correlation lower. In a turn of the year effect, investors rotate from e.g. large to small, momentum to value, etc. which pushes correlation lower. The impact of the US earnings season in late January / early February is also highly significant. Indeed, correlations tend to reach their lowest point during the Q1 earnings season, which is typically followed by a sharp increase into March quarterly options and futures expiry. Quarterly expiry cycles (March, June, Sep, Dec) are dominated by index trading activity and sparse flow of stock specific news. Figure below right shows the seasonality of correlations, as well the trend towards more pronounced seasonality, likely driven by the increase in passive assets. We believe correlation will start rising.
Given that the average volatility of individual stocks and sectors has been remarkably stable (at ~20%, and 13% respectively), an increase of correlations would drive market volatility higher. Correlations will increase from these levels, which will likely push short term S&P 500 realized volatility up to ~4% higher (i.e. from 6% to 10%, assuming single stock volatility stays constant at ~20% and correlations increase from ~15% to 35%).
This type of volatility increase would cause a meaningful de-leveraging of strategies such as volatility targeting and risk parity. For instance one could see ~$40-50bn equity outflows from volatility targeting strategies, ~$20-30bn from risk parity strategies, and additional outflows from other strategies on account of increased level of market risk. While this on its own may not cause the market correction, it represents a significant risk that is building up.
In addition, if the overhang of market makers’ long gamma positions wears off, this his could add an additional ~2% volatility points (for this to materialize investors would need to add / roll protection higher, or the market would need to slide lower by 1-2%). Indeed, many investors watched the past few days how the S&P 500 was squeezed higher, and there was frenzied buying of upside call options. This was not as much a bullish sign, but in part caused by closing of large option positions that were supplying upside S&P 500 volatility and gamma (mentioned in our August report). As was the case with other systematic strategies (volatility targeting, CTAs, etc.), low market volatility forced investors to increase leverage in short volatility systematic strategies as well (which results in either selling more options, or selling riskier, closer to the money options, leading to potential accidents).
A closely related technical risk is the potential for an unwind of short bond positions. In the aftermath of Trump’s election, trend-followers (e.g. CTAs) reversed bond positions from a record long to record short. Figure below left shows that speculative bond futures positions are currently near all-time lows. Figure right shows the exposure (beta) of CTA funds to 10Y bonds, and the net speculative bond futures positions over the past year. As we pointed out shortly after the US elections, we think that market participants embraced an oversimplified fundamental narrative on Trump’s impact on financial markets. In particular we think that a stronger dollar and significantly higher rates were in part driven by CTAs and carry trades, rather than just a change in fundamental outlook. The fundamental narrative has been unraveling recently and may further come under pressure if bond shorts and USD longs continue to get unwound. Investors may again interpret some of these systematic flows as a fundamental signal (this time bearish i.e. risk-off). This could in turn negatively impact e.g. financial stocks, or lead to broader equity weakness. As we argued in our last note, such a pullback likely wouldn’t be deep and would revert relatively quickly.
Geopolitical Risk: Investors are increasingly worried about geopolitical risk. Elections risk in Europe (e.g. France) is keeping many investors on the sidelines of otherwise cheap(er) markets. We are of the view that political changes in Europe are inevitable and reflect an expected popular reaction to two persistent pressure points: 1) a common currency that is too strong for less developed European economies (which some see as ‘gutting out’ the periphery), and 2) demographic and social tensions that are related to recent waves of immigration (e.g. the majority of Europeans would support an immigration ban even more radical than the one proposed by Trump). These pressures will continue to boost left and right populism, respectively. Once these issues are addressed in a substantial and constructive manner, tail risk in Europe will decrease (rather than increase). Populist victories (e.g. as was the case in Brexit and the US election) in that sense may act as a release valve for tensions, stabilizing the system long-term. The alternative of keeping the status quo or entrenching in ‘irreversible’ positions on matters such as political or currency unions, geopolitical commitments and partnerships, etc. long-term de-stabilizes the system and can lead to more radical and disruptive changes.
Finally, in our 2017 derivatives outlook published in December, we highlighted that a stronger dollar and higher rates are the main risk for equity markets. Since the February Fed meeting, this risk has somewhat abated. Moreover, we believe investors are not taking into account the fact that within just a year, the Fed’s composition will be very different. New Fed appointments (including for the Chair) will be nominated by president Trump, and are more likely to have similar views on market critical issues such as the value of the dollar, fiscal expansion and debt. This may open the door to a higher tolerance for inflation, weaker USD, and continuation of monetary accommodation. We believe investors would benefit from starting to position accordingly.