On January 3, JPMorgan’s Marko Kolanovic lamented that during December, “the confidence of equity investors virtually collapsed”.
In the note from which that quote is excerpted, Marko documented the factors that contributed to the December swoon. “Already fragile sentiment was undermined by political uncertainty from the US administration, the December FOMC meeting, a slowdown in economic data, and a viciously negative news and social media cycle”, he wrote, adding that those exceedingly unfortunate developments “brought a large amount of selling from mutual fund investors in an environment of poor liquidity.”
But while equity investors’ confidence might have “virtually collapsed”, Marko’s confidence was generally unshaken, which is why he retained his 3,000 price target for the S&P.
Fast forward to Valentine’s Day, and Marko rather dryly noted that “following the January rally, our S&P 500 price target (3000) 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.”
Fast forward another five weeks and guess what? We’re within shouting distance of that 3,000 target and when it comes to correctly calling the bottom, we would remind you that, as mentioned above, Marko’s first note of 2019 hit on January 3 or, more to the point, literally the day before Jerome Powell ushered in the “epic” pivot with comments in Atlanta.
So, there’s that, which speaks for itself.
But just in case it doesn’t (speak for itself, that is), Marko will now speak for it, via a new note, out Thursday.
He kicks things off by reiterating that this has been an under-owned rally, something we and plenty of others have written voluminously about over the past month or so.
“We’ve seen an impressive S&P 500 YTD rally (Sharpe ratio of over 4) and have recovered all losses since the October 10th selloff (i.e., strictly speaking bearish calls since then were wrong)”, Kolanovic writes, adding that “earlier this year, it was virtually a consensus that the rally was not sustainable and that a ‘retest’ of the Q4 lows was imminent.” As such, investors of (virtually) all stripes were reluctant to jump on board and that includes both systematic investors and the fundamental/discretionary crowd.
That raises the following questions (from the note):
- Why was the Q4 2018 selloff and subsequent rally so violent?
- How could these moves have happened without a large shift in positioning?
- Is the current rally sustainable?
For Kolanovic, “the answer to all of these questions lies in market liquidity.”
Obviously, 2018 was a year that saw multiple instances of liquidity disappearing and, generally speaking, market depth was severely impaired throughout the entire year. Jitters about year-end effects notwithstanding, it didn’t seem like things could possibly get much worse on the liquidity front headed into December, but alas, they did.
Marko takes up this issue in detail on Thursday. If you’re wondering whether “this time was different”, so to speak, the answer, from a liquidity perspective, is “yes.” To wit, from Kolanovic:
Figure 1, below, shows the Q4 2018 market selloff (starting 9/20) and recovery, as well as the last 5 selloffs (since 2008). One can see that the duration of past corrections is consistent with the current recovery and market reaching new all-time highs in 1-3 months. What is drastically different with the Q4 selloff relative to other selloffs in the past decade is the market liquidity (market depth). This is shown in the table in the inset. Specifically the average liquidity during the last selloff and recovery was less than 1/3 of the liquidity in previous episodes (and about half of the worst liquidity drawdowns of the last decade).
Considering that demonstrable lack of market depth, it’s no surprise that the selloff was so violent and the bounce so dramatic.
“Given liquidity, it is plausible that just short covering, buybacks, dealers’ gamma hedging, and some limited releveraging drove the entire recovery [and] this, in turn, opens the possibility that the current rally can continue during the spring”, Marko goes on to write.
Does Kolanovic think the Fed pivot has the potential to turbocharge the rally (or at least to provide a bullish tailwind for risk assets)?
In a word: “Yes”.
In several words, Marko reminds you that since things started to fall apart in earnest late last year, four hikes have been priced out, an end date to runoff has been announced and now, talk of a tweak in the way the Fed thinks about inflation is all the rage.
“This is an enormous shift in monetary policy, which we believe is not fully priced into various assets such as risk-on currencies, and Equities, Commodities, and other Value assets”, he contends.
Of course there’s still a lot of fear out there and Kolanovic addresses a handful of the biggest worries in a separate section of the note. We’ll get to that later, but for now, we’ll leave you with the general takeaway which is as follows:
In fact, if the market is left alone to its own devices (e.g., no disruptions from Trump, Brexit, etc.), it is most likely to drift higher on continued re-leveraging. Volatility is being suppressed by dealers’ long gamma positions, and the volatility targeting community is adding nearly ~$2bn of equities per day (December volatility spike is fading). Soon enough, CTAs could be adding to equity positions, and buybacks are continuing at near-record levels. Institutional positioning is still very low, which could be a source of additional demand.