Fresh off suggesting that Bitcoin and other cryptocurrencies have all the hallmarks of a pyramid scheme JPMorgan’s quant wizard Marko Kolanovic (affectionately known as “Gandalf”) is back with a new note.
Lucky for the bulls, there’s “good” news.
“With the upcoming positive Q3 earnings season, uptick in global growth, promise of tax reform keeping fundamental funds invested, and low volatility keeping systematic strategies invested, near-term risks of a selloff have abated,” Kolanovic says, in a note out Tuesday.
His advice? Stick with the rotation theme in small-caps, financials and value.
Of course there’s a downside here and it’s the same as it ever was: that ostensibly “good” news will end up being “bad” news for risk assets because as we noted earlier this morning, the better the outlook, the more likely it is that central banks pull back.
Here’s Marko:
Positive developments may encourage central banks to proceed with normalization, setting the stage for the end of the cycle.
And what does Kolanovic think the next crisis will look like? Well, “the next crisis’s main feature will be severe liquidity disruptions resulting from market developments since the last crisis,” he says. Here are the those developments:
- Decreased AUM of strategies that buy value assets
- Tail risk of private assets
- Increased AUM of strategies that sell on autopilot
- Liquidity-provision trends
- Miscalculation of portfolio risk
- Valuation excesses
So you know, “just” those. Note that the “increased AUM of strategies that sell on autopilot,” is of course a reference to the perennial Gandalf bogeymen: CTAs, risk parity, and vol. control strats or, the systematic/programmatic crowd.
We’ll leave you with one more Gandalf quotable:
While we think unlikely, a tail risk could be a backlash against central banks that prompts significant changes in the monetary system. In many possible outcomes, inflation is likely to pick up.
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Here’s the detail on the bullet points above:
We think the main attribute of the next crisis will be severe liquidity disruptions resulting from market developments since the last crisis:
- Decreased AUM of strategies that buy Value Assets: The shift from active to passive assets, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns. The ~$2T rotation from active and value to passive and momentum strategies since the last crisis eliminated a large pool of assets that would be standing ready to buy cheap public securities and backstop a market disruption.
- Tail Risk of Private Assets: Outflows from active value investors may be related to an increase in Private Assets (Private Equity, Real Estate and Illiquid Credit holdings). Over the past two decades, pension fund allocations to public equity decreased by ~10%, and holdings of Private Assets increased by ~20%. Similar to public value assets, private assets draw performance from valuation discounts and liquidity risk premia. Private assets reduce day-to-day volatility of a portfolio, but add liquidity-driven tail risk. Unlike the market for public value assets, liquidity in private assets may be disrupted for much longer during a crisis.
- Increased AUM of strategies that sell on ‘Autopilot’: Over the past decade there was strong growth in Passive and Systematic strategies that rely on momentum and asset volatility to determine the level of risk taking (e.g., volatility targeting, risk parity, trend following, option hedging, etc.). A market shock would prompt these strategies to programmatically sell into weakness. For example, we estimate that futures-based strategies grew by ~$1T over the past decade, and options-based hedging strategies increased their potential selling impact from ~3 days of average futures volume to ~7 days of average volume.
- Trends in liquidity provision: The model of liquidity provision changed in a close analogy to the shift from active/value to passive/momentum. In market making, this has been a shift from human market makers that are slower and often rely on valuations (reversion), to programmatic liquidity that is faster and relies on volatility-based VAR to quickly adjust the amount of risk taking (liquidity provision). This trend strengthens momentum and reduces day-to-day volatility, but increases the risk of disruptions such as the ones we saw on a smaller scale in May 2010, October 2014 and August 2015.
- Miscalculation of portfolio risk: Over the past 2 decades, most risk models were (correctly) counting on bonds to offset equity risk. At the turning point of monetary accommodation, this assumption will most likely fail. This increases tail risk for multi-asset portfolios. An analogy is with the 2008 failure of endowment models that assumed Emerging Markets, Commodities, Real Estate, and other asset classes are not highly correlated to DM Equities. In the next crisis, Bonds likely will not be able to offset equity losses (due to low rates and already large CB balance sheets). Another risk miscalculation is related to the use of volatility as the only measure of portfolio risk. Very expensive assets often have very low volatility, and despite downside risk are deemed perfectly safe by these models.
- Valuation Excesses: Given the extended period of monetary accommodation, most of assets are at their high end of historical valuations. This is particularly true in sectors most directly comparable to bonds (e.g., credit, low volatility stocks), as well as technology- and internet-related stocks. Sign of excesses include multi-billion dollar valuations for smartphone apps or for ‘initial cryptocoin offerings’ that in many cases have very questionable value.
