Here it is Tuesday, nearly a week on from the worst drawdown for U.S. equities since February, and we’re all still playing the victim.
Selloffs following record highs should probably be viewed as some semblance of cathartic, but that’s not the way people think about things in the post-crisis world. Drawdowns are generally seen as offensive these days. Selloffs are an affront to decorum; a sign that something went “wrong” and that we, the investing public, deserve to know who was responsible.
And so we sit, on the right side of the one-way glass, pondering a lineup of the usual suspects, hoping that if we squint hard enough at the cabal of possible culprits assembled on the wrong side of that same glass, we can discern something from their mannerisms that suggests which ones are culpable.
CTAs took a lot of the blame for last week. If risk parity is the scary bogeyman that nobody wants to implicate for fear of being publicly castigated by the likes of Ray Dalio, the trend followers are the red-headed stepchildren of the quant community. We all feel free to beat them mercilessly when nobody else will fess up.
On that score, it looks to me like the SG CTA index just had one of its four worst 5-day runs since the financial crisis:
(Bloomberg)
When you consider that in conjunction with the following chart from JPMorgan which shows short-term momentum signals abruptly turning short last week, you come away feeling justified for pointing the finger at CTAs, as it does indeed look like they were forced into amplifying the rout:
(JPMorgan)
But don’t be afraid to finger the risk parity crowd just because they’re the scariest looking bunch in the lineup. After all, the proximate cause for market angst headed into last week’s rout was a flip in the sign of the equity-rates correlation and that spells trouble for risk parity and balanced funds.
“A key concern has been the combined sell-off in equities and bonds, which has weighed on multi-asset portfolios, similar to February [and] at one point the initial sell-off in equities and bonds led to one of the worst periods for simple risk parity strategies since the GFC”, Goldman wrote on Monday evening, before driving the point home with the following rather poignant visual:
(Goldman)
If you look at risk parity and balanced mutual fund beta to the S&P, it’s pretty clear they de-risked this month, perhaps helping to accelerate the rout.
But in the same note from which the above JPMorgan chart was pulled, the bank’s Nikolaos Panigirtzoglou suggests you shouldn’t exempt discretionary market participants when you assemble your lineup. Specifically, Panigirtzoglou writes that the rolling equity beta of the Long/Short crowd “collapsed over the past week from the very high levels seen in September”.
(JPMorgan)
Remember that “grab” for exposure that found hedge funds playing catchup in August to benchmarks that had left them behind when a pullback in the dollar helped catalyze a fleeting reprieve for beleaguered EM assets, which in turn spurred a bout of risk-on sentiment that allowed U.S. stocks to summit what, at the time, were fresh highs? Yeah, well it looks like maybe that “grab” might have left some folks overexposed.
“The worst performing fund categories so far this month to October 10th were Equity Long/Short hedge funds (-3.3%) followed by Risk Parity funds (-2.8%) and Balanced mutual funds (-2.8%)”, JPMorgan noted on Friday.
(JPMorgan)
In light of all that (and with the figures in that table in mind), it’s worth mentioning that according to Nomura, Global macro funds might have seen last week’s rout coming and positioned accordingly. Now, the bank postulates, they (Global macro funds) may be unwinding bearish positions.
“Global macro funds have tried to take profit from their short US equities positions built since July [and] they may be viewing the current US stock correction as a good opportunity to buy back stocks at lower price levels”, Nomura writes, in a note dated Tuesday, adding that these funds “have also been gradually exiting short EM stock positions.”
(Nomura)
The bank goes on to say that the Global macro crowd is likely viewing a perceived bottoming in EM econ downside surprises as an indication that pressing shorts on developing economy equities from here could be met with diminishing returns.
This would be generally consistent with the thesis behind the “convergence” trade, which hinges on the assumption that the disconnect between the U.S. and the rest of the world (both in terms of equity momentum and economic performance) is likely to “correct” itself, with EM playing catchup.
More broadly, though, Nomura’s thesis is just another piece of the puzzle when it comes to determining where demand for equities will come from and who the marginal buyer will be at any given time. This has become an especially important debate in light of recent events which, again, suggest that the threat of sudden downdrafts is very real indeed.
“While systematic trend-followers such as CTAs continue to put selling pressure, global macro funds, which are good forecasters of future market conditions, have softened their bearish stance on global equities, and we think this can be viewed as evidence of a gradual improvement in supply and demand conditions”, Nomura concludes.
So I don’t know, maybe don’t include that crowd in the lineup as you skip Tuesday’s massive equity rally in favor of spending another day trying to figure out who accosted you last Wednesday.
