JPMorgan Asks: ‘Has The Marginal Equity Buyer Gone?’

I guess you can’t blame investors being a bit shell-shocked.

I mean after all, it was just a month ago when the VIX ETP rebalance risk that everyone summarily dismissed as an urban legend (at least in terms of whether it would trigger a black swan vol. shock) was realized, thus putting to bed the idea that the potential for those products to create chaos was old wives’ tale.

During that same bout of flash-crashing madness, market participants also learned that the systematic deleveraging bogeyman was real, when CTAs turned in their worst week in history and between the trend followers and risk party, some $200 billion in equity exposure was unwound.

No sooner had that run its course that Jerome Powell fumbled his first public testimony as Fed Chair and an “unglued” Donald Trump started a trade war.

The events that transpired this week served as a poignant reminder that “technical” risks aside, there are also more fundamental issues at play, not the least of which are the inherent dangers of installing a new Fed Chair at a critical juncture and allowing a reality TV show host to dictate America’s trade policy.

You’ll recall that investors plowed a ridiculous sum on money into equities in January only to yank it right back out amid the February turmoil.

Well in the latest installment of his weekly Flows And Liquidity note, JPMorgan’s Nikolaos Panigirtzoglou asks the following rather disconcerting question:

Has the marginal equity buyer gone?

By that he means retail investors. Here’s Panigirtzoglou:

We showed last week that equity ETF buying had been improving over the previous two weeks following a large outflow of $20bn in the week ending Feb 8. We noted that this improvement was important for the bullish thesis, as it will take some time until momentum improves and vol normalizes inducing institutional investors including CTAs and other trend following investors to start building up long equity positions again. In other words, we had hoped that retail investors, perhaps induced by “buying the dip” mentality, were emerging as the marginal buyer of equities. This past week has shaken this hope for two reasons. 1) This week has been one of the most erratic in terms of equity ETF flows, with a large inflow on Monday and Tuesday being reversed on Wednesday and Thursday (Figure 1). 2) For the first time since the correction began, the outflows spread out to ETFs that invest outside US equities.

Why is the retail bid so important? Well, for two reasons. The first is that, according to Panigirtzoglou’s colleague Dubravko Lakos-Bujas, the vaunted corporate bid (i.e. buybacks) may operate with a delay.

But perhaps more concerning is the deterioration in liquidity. This discussion goes back to the long-held contention of many HFT critics that the proliferation of algos actually sucks liquidity from the market at critical times – that is obviously the polar opposite of what HFT proponents will tell you. Here’s Panigirtzoglou rehashing the argument:

These agency traders tend to show lower commitment and tend to withdraw from market making more quickly than principal traders once order flow imbalances emerge and uncertainty and volatility rises. The more frequent occurrence of so called “flash crashes” in equity markets is often blamed on the opportunistic behavior of these market makers. There is high likelihood that a more defensive behavior by market makers has worsened market liquidity, exacerbating market movements over the past weeks.

In addition to that, there’s now a new problem – MiFID II. To wit:

The restrictions imposed on off exchange trading and dark pools by MiFID II might have also had an adverse impact on market liquidity this year. We argued before that the high share of off-exchange trading, a phenomenon that has persisted in both Europe and the US, suggests that there is genuine high demand for off-exchange or dark liquidity to reduce the market impact of large trades by big institutional investors. To the extent that MIFID II induces too much shift away from less transparent or off-exchange trading venues to fully transparent real-time on-exchange reported trading, then liquidity could be potentially impaired also.

So just how acute is the problem in the wake of February’s stumble? Well, pretty acute. Here’s a chart of the Hui-Heubel ratio (I’ll save you a Google search: it’s a price to volume based indicator of vol. for E-minis):

“[That] shows that there has been a significant deterioration in the market breadth of the S&P500 Emini futures contract over the past month,” Panigirtzoglou writes, summarizing, before cautioning that “not only has this indicator deteriorated to levels last seen during the August 2015 correction, but the deterioration appears to be more persistent relative to then.”

The bottom line – i.e. skipping straight to the point because you know, it’s Saturday and all – between that and skittish retail investors as outlined above, you better hope what’s evident in the following chart from the above-mentioned Lakos-Bujas not only materializes, but in fact materializes quickly in the event of a sudden downdraft: