Kolanovic: Tuesday Was “No Surprise,” Should “Not Be Fitted To Political Narrative”

Just hours before Wall Street’s “Gandalf” weighed in on the proximate cause of Tuesday’s equity meltdown, we asked a simple question: “Is Marko Kolanovic Right?”

In that post, we explained (again) why CTAs (the trend followers), risk parity, vol targeting, and other programmatic/systematic strats may pose a systemic risk to the extent they exacerbate large drawdowns.

As noted, it’s likely that these strats are overexposed to equities given recent one-way price action and still suppressed vol. Additionally, we showed you the chart in the right pane below to give readers an idea of just how large these strats’ collective footprint has become.

(Goldman, BofAML)

Well as mentioned above, just a few hours after our post Kolanovic explained what he thought was behind yesterday’s action. Below, find the note.

Via JPMorgan

In a note published last week we pointed to the risk of an equity pullback and explained how option expiry will lift the lid from market volatility and put downward pressure on stocks. Following Friday’s option expiry, the gamma imbalance shifted towards puts for the first time in ~5 months and the market was ‘free’ to move again. Hence, it should not be a surprise that today, for the first time in ~5 months, we have a meaningful down move and intraday acceleration. The S&P 500 option gamma imbalance turned ~$20bn towards puts today, significantly contributing to the selling. In addition, we had a break in short term momentum (1M momentum) that may cause modest equity selling by CTAs, and an uptick in realized volatility is also starting to cause outflows from volatility-sensitive investors. Last week as well as last month, we reiterated that the technical covering of record bond shorts (e.g. by CTAs) may lead to pullback in financial stocks (note financials are down ~5% over the past week) and provide a ‘fundamental’ narrative to this largely technical selling. We maintain that the market is entering a vulnerable phase, where increased volatility can further contribute to equity outflows. While we don’t want to minimize the impact of political developments, today’s move was primarily technical and should not be fitted into a political narrative (which in fact was neutral between developments in France and US).

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Here is our full post from Tuesday for reference and context.

One of the points we’ve been pretty keen on driving home here over the past couple of months is that the type of programmatic/systematic strats that JPMorgan’s quant “wizard” Marko Kolanovic so often warns about might well exacerbate a large drawdown should such an event eventually come calling.

As a reminder, here’s what Kolanovic said last month with regard to CTAs and the massive Treasury short:

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.

In other words, if the Treasury short gets covered (and again, note CTAs’ beta to the 10Y in the right pane above and think about the extent to which the 10Y short was trimmed last week despite the overall UST short remaining large), markets may interpret that as a risk-off signal, leading to equity weakness.

Well, speaking of CTAs and equities, it seems likely that their exposure is running high given recent one-way price action. Recall this from Goldman:

Low volatility and trending markets tend to attract systematic investors, whose size and impact has increased in recent years. CTAs (Commodity Trading Advisors) are trend-followers or momentum investors that mostly use futures — if the market shows a clear uptrend there is a strong chance that CTAs are long the market. The beta of two main indices tracking macro HFs and CTAs to the S&P 500 has soared in recent months and is close to its highest levels since the 90s (Exhibit 16).

In the event of a reversal of the trend, these systematic investors are likely to reduce equity exposure quickly, which could exacerbate an equity drawdown and result in a faster and larger volatility spike.

And then, with the chart in the right pane which flags a similar risk from risk parity in mind, note the rather dramatic increase in the size of these funds’ footprint (BofAML has added Bridgewater’s All Weather fund to the visual, which helps you get an idea of why Kolanovic is so intent on warning about the risks posed by these strats as a group):

And finally, recall the following chart from JPMorgan (note the CTA beta):

So with all of that in mind, consider the following from FT, who notes that markets have a short memory when it comes to sh*t that turns out badly…

Via FT

On Wall Street, bad ideas rarely die. They often go into hibernation until resurrected in a new form. And portfolio insurance – a leading contributor to the 1987 “Black Monday” crash – is, for some, making a return to markets.

Institutional investors are allocating billions of dollars to “risk mitigation” or “crisis risk offset” programmes that are designed to act as a counterweight when markets are in turmoil. They mostly comprise long-maturity government bonds and trend-following hedge funds, which tend to do well when equities plummet.

But some analysts and fund managers worry that if taken to extremes, allocations to trend-following “commodity trading advisors” hedge funds, in particular, could play the same role as an investment concept called portfolio insurance did in 1987, when it was blamed for aggravating the worst US stock market collapse in history.

“There’s a big portfolio insurance industry that no one is talking about . . . CTAs are dangerously close to portfolio insurance,” argues Robert Hillman, the head of Neuron Advisors, a London-based quantitative asset manager.

CTAs, which are also called managed futures funds, are computer-driven vehicles that take advantage of financial markets’ tendency towards momentum. Assets that have gone up tend to go up further, and assets that are falling typically continue to slide.

CTAs therefore often automatically bet against an already-falling market, shorting it to profit from further declines, and usually thrive when other strategies are unravelling. They did extremely well in 2008, and at the start of 2016, when markets were in a tailspin over China’s economic slowdown. Despite losing their footing when markets rebounded last year, their reputation as crisis-mitigators was burnished.

[…]

But the rise of CROs and similar insurance programmes using trend-following funds is causing disquiet, including inside the CTA industry that has benefited from the trend. David Harding, the head of Winton Capital and one of the industry’s biggest names, warned in an investor letter late last year that using simplistic trend-following strategies for protection was akin to the portfolio insurance idea that proved so destructive on Black Monday.

“When an institution allocates to a momentum strategy in the hope of cushioning itself from stock market downdraughts it is really commissioning someone to sell stocks on its behalf into a falling market; no different to the failed portfolio insurance strategy that was implicated in the 1987 crash,” he wrote. Mr Harding declined to comment beyond the letter.