A couple of days back, we said that if we had to guess, we’d be inclined to think JPMorgan’s Marko Kolanovic would be on the record with something new in relatively short order in light of recent market events.
When last we checked in on perhaps the Street’s most recognizable name, Kolanovic was outlining the “liquidity-volatility-flows feedback loop” that serves to perpetuate downside momentum when things get moving in the wrong direction.
In the same piece, he also weighed in on the the extent to which the psychological effects of Fed balance sheet runoff are likely more damaging than any mechanical impact on risk assets in an environment where the above-mentioned feedback loop is in play and the social media echo chamber is particularly efficient at magnifying fear (see Trump’s “50 Bs” tweet, for example).
The self-feeding nature of a dynamic where systematic flows can (and do) collide with diminished liquidity (i.e., an acute lack of market depth) to exacerbate price swings thereby driving volatility higher and perpetuating that same lack of liquidity was in part responsible for the worst December for stocks since the Great Depression.
As Marko lamented early last month, “confidence virtually collapsed” at the end of the year, and the situation was made immeasurably worse by market participants becoming lost in their own reality distortion field vis-a-vis the “imminent US recession” narrative.
Through it all, Kolanovic stuck with a 3,000 price target for the S&P in 2019 and in his latest update, out Thursday afternoon, he notes that “the December-January V-shaped move was one of the most prominent in a century, and occurred despite no improvements in the fundamental outlook.”
He then quips that “following the January rally, our S&P 500 price target is no longer considered outlandish by most [and] calls from various strategists for a 1929-style recession, rolling bear market, or imminent retest of lows are now getting quieter.”
Kolanovic’s call for a bounce was predicated on a short covering rally and the resumption of inflows tied to falling volatility. As a reminder, the one-month collapse in vol. was one of the most dramatic such episodes since 1928.
Suffice to say the doomsday blogs didn’t nail that one.
In his Thursday note, Marko delivers an update on positioning and essentially confirms that a lot of folks (and “folks” need not necessarily mean “carbon-based lifeforms” in this context) are still underexposed. We’ve talked about this at length over the past week, whether in the context of the fundamental/discretionary universe and/or the vol.-targeting crowd.
“With declining volatility and rising prices, Hedge Funds increased their gross exposure, but they did not significantly increase net exposure”, Marko writes, adding that JPM’s prime data shows net equity exposure sitting at just the 6th percentile while the equity beta of the global hedge fund index is still low (15th percentile).
“Multi-asset risk controlled portfolios still have very low exposure to stocks”, he goes on to write, noting that based on his “survey of quantitative clients’ volatility targeting practices… the equity exposure and overall leverage of this market is still very low” where that means close to the 10th percentile.
As far as the trend followers, it doesn’t sound like Marko concurs with the contention that they’re back in the game on the long side. To wit:
Interestingly, these investors are still short equities, despite the recent rally. With various trend signals turning positive (e.g. 3M and 12M for S&P 500, and 1M for various international indices) one would expect these investors to start adding equity longs.
Importantly, Kolanovic notes that “given the market rally, dealers’ gamma positioning is neutral or long”, which removes a possible accelerant and should help tamp down volatility, catalyzing “further re-levering of various investors.”
What does all of that mean? Well, it suggests that this is to a certain extent a rally that nobody owns (if you will). That could well presage more buying assuming the market continues to move higher and vol. remains suppressed.
As far as the risks, Kolanovic cites the trade talks, but he notes that the “decline in the President’s approval rating on the back of the government shutdown and Q4 market selloff, may result in some market stability near term and may improve the likelihood of a positive outcome from trade negotiations.”
If you’re wondering when things could get dicey again, Marko recommends watching the assumed re-risking from some of the investor types mentioned above. Specifically, he reiterates that we’re sitting in and around the ~10-20th percentile “and one could run long until exposure reaches the ~70-80th percentile, when the risk of another market seizure increases.”
How long might the re-risking cycle last in the event volatility does remain low and the strats and investors mentioned above are pulled back in (either mechanically or otherwise)? We’ll leave you with Kolanovic’s answer:
This re-levering cycle could last between now and e.g. May (in which case, we could go back to the normal ‘sell in May’ seasonal schedule this year).