Sophia Don’t Fail Me Now: One Bank Worries ‘Algo Rally’ Will ‘Run Out Of Steam’

On Monday, we noted that markets are now “torn”, with investors pulled in one direction by an express desire to extend the YTD risk surge catalyzed by the dovish Fed pivot and yanked in the other by ongoing signs of economic malaise (China’s December trade data), the US government shutdown and the ever present threat that someone, somewhere is going to step on a geopolitical landmine (e.g., Brexit, China vs. Canada, Turkey vs. Kurds).

Tuesday brought more in the way of conflicting signals as more stimulus banter out of Beijing argued for an extension of the rally while lackluster results from JPMorgan underscored the notion that anyone who was inclined to overlook Citi’s FICC miss on Monday might have made a mistake.

There’s also palpable consternation around the extent to which the rally in equities has been largely a function of short covering, CTA re-leveraging (as momentum signals flip) and some fundamental/discretionary investors succumb to a “force-in.”

“[The] shorter-term signal for EM equities turned long earlier this week, as did the signal for the Eurostoxx 50, suggesting that a short covering by momentum-based investors has contributed to the rally in equity markets”, JPMorgan wrote on Friday, for instance.

Meanwhile, the rally in high yield is “suspect”, where that just means the ferocity of the move (junk spreads tighter by ~90bps off the wides hit ahead of Powell’s Atlanta speech) is probably down to a dearth of HY supply and action in the ETFs.

All of the above raises questions about how far things can run in the absence of another fundamental catalyst and Nomura’s Masanari Takada is out underscoring that point in a note dated Tuesday.

“All major stock price indexes have been approaching technically important levels (e.g. ~2,600 of S&P500, ~1,450 of Russell 2000 etc), so CTAs are being gradually forced to cover their ballooned short positions for now”,  Takada writes, before warning that “on the other hand, some speculative players that retained a cautious stance in terms of fundamentals might be selling US equities on the rally.”

(Nomura)

Again, the issue is that if you were forced (gun to your head) to come up with a list of concrete developments that would justify the rally off the December 26 overnight lows (illustrated in the simple, yet poignant visual below), you’d be hard pressed to get much further than “dovish Fed pivot”, “December payrolls” and “upbeat soundbites on trade.”

(Bloomberg)

That demonstrable lack of concrete positive developments has Nomura concerned.

“Some algo investors like CTAs and Risk Parity funds could have started to buy back US stocks in an automated response to the rebound of market trends as well as the decline in price volatility”, Takada goes on to say, before driving the point home as follows:

However, relative to the rebound in market momentum, fundamental improvements have not been enough and we are somewhat wary of the lack of balance between them.

Yes, Nomura is “somewhat wary of a lack of balance” between how far markets have run since the Christmas Eve massacre and, well, and reality, where “reality” is defined by, among other things, i) the longest US government shutdown in modern history, ii) the high likelihood that all assurances notwithstanding, Erdogan will try to decimate the YPG once the US pulls troops out of Syria, iii) a (virtually) guaranteed defeat for Theresa May’s Brexit plan, and iv) no signs that the slowdown in global growth is abating.

Of course algos aren’t “thinking” about any of that, and that’s where the problem comes in. CTAs will chase the trend and vol.-control strats will rebuild exposure (albeit slowly) if volatility manages to stay contained for long enough.

Meanwhile, the “world is blowing up around us“, to quote the actual President of the United States.

The bottom line for Nomura’s Takada is captured in the headline of the note: “Will a risk-on market rally based only on algos run out of steam soon?”

Who knows – maybe ask Sophia.