In case you haven’t noticed, market commentary has devolved into something of a parlor game these days, wherein journalists, analysts and pundits of all stripes are engaged in a daily effort to expound on the myriad “risk factors” casting a pall over the outlook.
Obviously, investing is about risk management and ensuring you’re getting compensated properly for whatever level of risk you’re willing to take in search of returns. But in the pursuit of clicks, social media followers and, I suppose, trading revenue, the multifarious voices that together comprise the daily cacophony have conspired to paint a picture straight out of The Matrix.
Every, single morning, a quick scan of the headlines suggests that everybody from Joe E*Trader to Jane multi-billion-dollar portfolio manager spends every waking hour in an insane gun battle where all that separates one from financial ruin is a physiologically impossible slow-motion backbend.
This is somewhat ironic considering that cross-asset vol. has now collapsed and I guess that speaks to the absurdity of this whole charade. Risk assets are up across the board in 2019 and volatility has flat-lined, but you wouldn’t know it by tuning into finance Twitter (“FinTwit”) or perusing the front pages of the mainstream financial news outlets.
There is, according to those “sources”, always something going on that you need to know about – 24 hours a day, 7 days a week.
To be clear, it is indeed possible to argue that things which, two decades ago, could safely be ignored by the vast majority of market participants are now highly relevant. Nobody (with the possible exception of one other blog) has spent as much time as we have documenting the interconnectedness of global economies and markets. The “butterfly effect” has never been more relevant for traders and investors than it is today and in an environment where liquidity can disappear in an instant, there is indeed a sense in which everything potentially “matters”.
But with that caveat, it’s important not to lose track of the fact that the echo chamber described above can (and does) amplify that butterfly effect. There is perhaps no better example of how the interplay between social media, a hysterical financial press, modern market structure “glitches” and a dearth of liquidity can produce highly undesirable outcomes than the December 5 crash in S&P futures coming off a day of mourning for President Bush and coinciding with the arrest of Huawei CFO Wanzhou Meng.
In a December 7 note, JPMorgan’s Marko Kolanovic specifically cited that incident as an example of how the interplay described above can end up manifesting itself in decidedly pernicious market outcomes.
Ok, so the 2019 surge in risk assets has been characterized by low participation (read: under-exposure and very low equity positioning) on the part of key investor groups (see here and here for more).
Arguably, one reason for that low participation is the psychological overhang created by the deluge of articles and incessant coverage of various “risk factors”. As JPM’s Kolanovic writes in his latest note, “some of the fears are justified more than others.”
At the risk of ascribing an opinion to Marko that he may or may not actually harbor, his recent notes seem to suggest that he isn’t particularly enamored with the extent to which market participants are perpetually bombarded with stories and analysis which create the impression that investors of all shapes and sizes are akin to a bunch of Marios, just one pixel away from getting swallowed by a man-eating plant or sliding off a block into the abyss.
So, in the interest of perhaps clearing the air, Kolanovic addresses what he calls “some of the potentially negative drivers that we believe are either not well understood or blown out of proportion by market commentators.”
He starts with quarter-end rebalancing, a boogeyman that comes up whenever equities have outperformed. This is of particular interest right now following the dramatic impact of rebalancing flows late last year, when a “historically large” flow served as a kind of “stick save” for US stocks, which were in free fall following the Fed meeting and amid government shutdown fears.
You might recall that the rebalancing flow documented in those two linked posts helped offset a massive mutual fund outflow earlier in the month. Those flows (the impact of which was exaggerated by a lack of market depth) were illustrated by Kolanovic in his January 3 note. Here are those visuals:
In simple terms, the concern is that with equities having rallied sharply, the quarter-end rebalance could undercut stocks in the same way the December rebalance helped catalyze a bounce off the Christmas Eve lows.
Marko thinks that risk might be overstated, or if “overstated” isn’t the right word, “misunderstood” will suffice. As it turns out, it’s monthly rebalancing that matters more. To wit, from Kolanovic’s latest:
We find the strongest effect is on monthly rebalance dates. The reason for this is that the monthly rebalance effect is reinforced by option expiry effect. In fact when one looks at quarter-end effects, and corrects for month-end effects, the quarterly impact is fairly weak in recent years (about one quarter of the monthly effect over the past 5 years). If one looks at longer histories, i.e., 10 or 20 years, the quarter-end effect does not exist at all (i.e., it goes the other way, see table below). Given that the market is up a lot since December-quarter-end, but is not up much on a month-to-date basis, we expect fixed weight portfolio rebalances to have only a small negative effect. Historical analysis would imply a less than ~50bps negative market impact from these rebalances.
So, there’s that.
How about blackouts, that other calendar ghost? Well, here again Marko thinks folks don’t have a solid grasp on how things actually work.
“We have seen reports that quarter-end rebalance effects will be made worse by the buyback ‘blackout’ period that starts ~1 month before earnings season i.e., end of March, [but] this is simply not the case, as individual companies enter blackout periods not ahead of the beginning of the earnings season, but ahead of their own reporting date”, he writes, adding that “this puts the peak blackout period in mid- to late April, rather than late March.”
Additionally – and this is something that, while widely acknowledged, is habitually ignored – blackouts only apply to discretionary buybacks and on JPMorgan’s estimates, 60% of programs aren’t affected by blackouts.
As far as whether you can just point to forward multiples and shout “sell” when the market rises above a certain percentile, the answer is “no”. I mean, technically the answer is “yes” because you can do whatever you want to do, but if you’re wondering whether that’s a strategy that backtests well, the answer is “no.”
That might well turn out different for extremes (i.e., P/Es above the 90th percentile or something), but outside of that, Kolanovic reminds you that “strategies that sell the market when P/E rises above and buy the market when P/E falls below certain P/E percentiles would have lost money historically.”
Moving on, Marko addresses Brexit and after dryly noting that “countless pages” of analysis have been written in an effort to discern how things will play out and what the market ramifications might be, he delivers a decidedly straightforward take on the situation. To wit:
While Brexit is important for UK assets and by extension Eurozone, our view is that Brexit will not change the outcome of the global economic cycle. Either the Chinese economy will have a positive inflection and any kind of Brexit will not derail the global cycle, or if China rolls over, no kind of Brexit will save the global cycle.
Speaking of the Chinese business cycle, that’s obviously where the real risk resides, and Marko doesn’t dance around that.
Over the past several weeks, the headline hockey around the trade conflict has cast considerable doubt over whether a deal is in fact imminent, despite Trump’s well-documented desire to get something announced in the interest of boosting equities.
And while the likes of Larry Kudlow will tell you it “simply is not true” that the president takes stocks into consideration when it comes to negotiating with Beijing, Trump himself has made it clear that the market does matter – a lot.
“[The trade deal] is probably the largest and most important market risk, as it may decide the fate of the business cycle in the US and China”, Kolanovic says, wrapping things up and adding that “while Trump does want to get US equity markets higher and avoid a recession going into elections next year, we worry about the administration’s ability to control some of its anti-trade impulses.”
So, does any of that necessarily “prove” that market participants’ fears are overblown or that the incessant barrage of “here’s what could go wrong” articles and analysis are unfounded and thereby have no place in daily market discourse?
Well, no. But Kolanovic’s efforts to “address” the pervasive “fear” which has clearly kept some key investor groups on the sidelines in the new year do speak to the idea that folks are being kept awake at night (to employ a tired cliché) by things they either don’t fully understand or else shouldn’t be all that concerned about.