This ‘Freakout’ Isn’t The ‘Big One’ – That Comes Later: Nomura’s McElligott

If you ask JPMorgan’s Marko Kolanovic, the October selloff in U.S. equities and the accompanying de-risking across systematic and discretionary investors may have set the stage for 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”, Kolanovic wrote, in a brief Tuesday note documenting the dramatic drop in hedge fund net exposure from near record highs at the end of September to the lowest since 2015 following this month’s rout.

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

Marko also noted that systematic de-risking has driven the equity exposure of the vol.-targeting crowd to its lowest since February, while “many CTAs are outright short or out of equities.”

Well, in his own Tuesday note, Nomura’s Charlie McElligott documents the same dynamics. “Systematic trend models show SPX and RTY inching closer to pivoting from a small net long to outright max short levels,” he writes.

(Nomura)

McElligott reminds you that any good news is quickly met with selling these days. The source of those selling flows is by now familiar.

“Legacy asset manager length in U.S. equities futures is being taken-down” Charlie writes, adding that we’re also seeing “VaR-induced mechanical exposure reduction from both fundamental- and systematic- funds.” He goes on to reiterate that part of this is attributable to the consensus/crowded longs selling off more than the active crowd’s underweights.

The story remains the same on the bullish side. The buyback blackouts are rolling off, the October washout has left positioning cleaner and seasonality is positive. The fact that those factors have yet to provide a reliable bid or otherwise put a floor under things “further bleeds sentiment and ammo to play offense”, McElligott goes on to say.

It doesn’t help that “Long-Short and Market-Neutral equities hedge fund performance has dropped to the lows of the year”, he adds. Have a look at this:

(Bloomberg)

I’ve beaten this horse to death over the past few weeks, but I’m going to emphasize it again here. These wild swings in Growth versus Value aren’t helping matters – at all. I used the following chart yesterday, and I’m going to use it again here:

Every time you get one of these days when Growth underperforms by a wide margin, it’s trouble. McElligott reiterates that on Tuesday. “The lack of counterbalancing flow from some equities real money to absorb the forced deleveraging is likely exacerbating the painful thematic/factor/sector reversals”, he warns, adding some further color to explain the “massive outperformance of short/underweighted Value over uber-crowded Growth.”

Over the weekend, while documenting evidence of cyclical jitters, late-cycle concerns and “peak profit” worries (more here), I flatly said the following:

This is, I would argue, being turbocharged by factor rotations and shakeouts in overcrowded legacy Tech/Growth positions. According to Goldman, Long/Short hedge funds had one of their worst days ever [last] Wednesday, and if you just think about how they’re positioned, it’s not hard to understand why.

Well, as it turns out, Monday saw the fifth worst one-day drawdown for Charlie’s U.S. Equities Long-Short HF model of the year. That, he says, came courtesy of more deleveraging tied to those same legacy positions I mentioned on Saturday.

“In particular, the extreme and much-discussed outperformance of U.S. equities Value over Growth yesterday optically looked just as much about selling longs and covering shorts as higher realized volatility dictates VaR-based exposure reduction as it did about ongoing end-of-cycle factor rotation catalysts or macro inputs (i.e. steeper curves benefiting Value)”, McElligott explains. I’m not entirely sure that’s comforting (and I don’t think he meant it to be). That is, I’m not sure what’s worse – mechanical, VaR-based de-risking or a continuation of the late-cycle factor rotation that effectively presages a recession.

Anyway, have a look at equities hedge fund performance and how those legacy positions continue to keep the pressure on despite dramatically lower exposure versus the September peaks:

(Nomura, Bloomberg)

What, ultimately, does McElligott think lies ahead? Well, he’s also in the camp that doesn’t believe the October selloff is “the one”.

Specifically, he says this “freak out” is just a kind of head fake, on the way to what will be “the early-to-mid 2019 event where after the 2^nd hike, the market sniffs the slowdown, the curve powerfully steepens, and we see the ultimate risk-off trade.”

So if you’re wondering when to really lean into that Growth-to-Value rotation that everyone has been waiting on for what seems like decades, there’s a hint.