Marko Kolanovic: October’s ‘Rolling Bear Market’ Could Morph Into A ‘Rolling Squeeze Higher’

Although U.S. stocks look poised for a decent session on Tuesday, the market is still on pace for its worst month since 2009.

The narrative here is reasonably clear. The bear steepening that preceded the early October drawdown was generally seen as product of the bond market “catching up” to the reality of the overheating U.S. economy. Equities digested rate rise well on October 3 – it was the “good” kind of bond selloff, driven by expectations of economic outperformance. The next two days (October 4 and 5) stocks’ interpretation changed – yields were rising too far, too fast. That threatened to flip the sign on the equity-rates correlation, leading to “diversification desperation”. That bear steepening episode also appeared to catalyze a rotation out of “slow-flation” plays or, more to the point, a Growth-to-Value rotation which in turn precipitated a Momentum unwind.

That was the setup for the October 10 technical selloff. The Long/Short crowd was already de-risking (underperformance in crowded longs), the sign flip on the equity-rates correlation sparked jitters about risk parity (and balanced funds more generally) and the downward pressure on equities eventually flipped the momentum signals, prompting deleveraging from the trend followers. Option hedging flows contributed. Etc. etc.

Fast forward two weeks and folks are worried about peak profits, end-of-cycle dynamics and a Fed that’s seen as too aggressive, even as the econ continues to generally support gradual hikes. Somehow (think: Donald Trump), the market seems to have flipped from being convinced that the economy’s blistering pace was well ahead of the Fed’s tightening pace, to the other way around in the short space of a couple of weeks.

Over the past week, the technical selling and systematic deleveraging that drove the early October rout has given way to de-risking by discretionary investors. As we and others have pointed out, the rout in Tech/Growth (i.e., your consensus slow-flation longs) and episodic violent rotations into Value, have spelled trouble for the Long/Short crowd. Last week, for instance, Goldman said Long/Short funds (a $900 billion+ universe) were down nearly 9% through October 23. Considering the representation of Tech/Growth in those portfolios, it’s probably safe to say last Wednesday was a disaster for them. Have a look at the following chart:

(Bloomberg)

It’s with all of the above in mind that JPMorgan’s Marko Kolanovic is out with his latest brief note which takes the form of a positioning update.

After noting that the de-risking baton has been passed from systematic selling to hedge fund de-risking, Marko notes that “the global HF equity beta dropped from the ~95th percentile in September to ~15th percentile now (over the past 5 years)”. That, Kolanovic writes, is “one of the largest and fastest declines on record.”

You’ll recall that earlier this month, JPMorgan’s Nikolaos Panigirtzoglou showed the rolling equity beta of the Long/Short crowd collapsing from elevated levels in September. For those who missed it, here’s the visual on that:

(JPMorgan)

In his Tuesday note, Kolanovic goes on to write that in addition to hedge fund exposure diving (and hedge fund shorting jumping to the highest levels since 2015), the systmatic crowd has now de-risked materially.

“Systematic investors are also near the bottom of their exposure – volatility targeting strategies’ equity holdings are similar to February lows, and many CTAs are outright short or out of equities”, he writes, before noting that “a ~10% decline from the peak and markets turning negative for the year triggered all kind of institutional stops, driving the sell-off deeper.”

So what comes next? For Kolanovic, the risk is now “that an October ‘rolling bear market’ turns into a ‘rolling squeeze higher’ into year-end.”

“With investors positioned defensively, and leverage rapidly coming out of system, there is an elevated risk of market reversion into year-end”, Marko says, adding that this would almost invariably mean further underperformance for active managers who, you’re reminded, were left behind in August as stocks rallied to highs while hedge funds were underexposed following the late-July Growth/Tech selloff that followed Facebook’s epic stumble.

What would serve as the rocket fuel for the type of “rolling squeeze” Marko sees as a possibility? Well, if you’ve been following along, that’s an easy question to answer. For one thing, rebalancing by the fixed weight crowd following the October rout could be substantial considering the depth of the selloff. Additionally, systematic de-risking could morph into systematic re-risking assuming volatility calms down and remains subdued into year-end. Finally, there’s the old standby: buybacks.