JPMorgan’s Marko Kolanovic is out with a new note on Monday and you can be sure it will be covered by both mainstream financial media outlets and the usual handful of market-focused blogs who are inclined to weigh in on notable sellside research.
As you peruse the various efforts to summarize Marko’s latest missive, do ask yourself what those outlets were saying back in early January when Kolanovic very calmly explained that US equities were likely to not only recoup December’s losses, but in fact make new highs in the months ahead. Specifically, he was steadfast in his call for SPX 3,000.
“Marko Kolanovic Cops to Bad Stock Call, Sees Bullish Signal From Retail Investors“, a Bloomberg headline from January 3 reads. And that’s pretty tame compared to some of the bombastic assessments delivered by outlets of lesser repute.
The bottom line is that Marko was correct. As he somewhat dryly put it on February 14, just six weeks into the new year, “calls from various strategists for a 1929-style recession, rolling bear market, or imminent retest of lows are now getting quieter.”
Well, if those dour calls were “getting quieter” by early February, they are silent now – as in crickets….
Over the course of the last four months, Kolanovic has variously explained what led to the December rout and has, on several occasions, maintained that due to persistent underexposure and the “flow-less” nature of the rally, stocks could climb further still, as key investor cohorts are “forced” in either by the siren song of FOMO or else mechanically. He also pointed out that a dearth of liquidity likely helped turbocharge the rebound the same way an acute lack of market depth exacerbated the selloff.
“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”, he wrote last month.
In Monday’s note, Marko reminds you right off the bat that in his mind, the rebound was never in doubt. “At the depths of the market selloff we maintained that a quick and full recovery is likely”, he writes, before rehashing the factors that have contributed to the upswing, including a string of better-than-expected data out of China, a still-firm US economy and muted inflation, which gives the Fed cover for a persistently dovish lean.
He then takes a jab at the earnings recession narrative. “Corporate fundamentals are holding up well too, and we expect positive earnings growth for Q1 (note the almost unanimous calls for an ‘earnings recession’ earlier this year)”, he chides, adding that with nearly half of S&P 500 companies reporting, ~75% of them have beaten EPS estimates by an average ~5%.
As far as the flows picture goes, Marko recaps how things have evolved from the three-day stretch where massive rebalancing flows sparked a U-turn off the Christmas Eve lows all the way up until this month. Here’s Kolanovic putting some numbers on things, and do note the last bit about record long gamma positioning:
After Christmas day, the market rally was started with pension rebalances, and continued with short covering by speculative investors. With the decline in realized volatility, systematic investors started re-leveraging, i.e. buying back equity exposure that was sold to the lowest point during the Q4. We estimated this systematic buying was roughly ~$250bn, and if volatility stays low these programs and platforms could add another ~$250bn before reaching maximum exposure. During Q1, corporates bought back a similar amount (~$220bn) and this ensured a smooth rally (64% up days vs. historical average of 52%). We have also witnessed a return of the ‘buy the dip’ market pattern, which is the result of inflows and intraday derivative hedging of nearly record long gamma positions.
Next, Marko reiterates that the fundamental/discretionary crowd has remained timid, even as some systematic re-leveraging took place and even as the insatiable corporate bid hitting in a low-liquidity environment pushed stocks inexorably higher.
“What has been remarkable for this rally, is that discretionary investors did not meaningfully increase their net equity exposure, and retail investors net reduced their equity exposure”, he writes. “In other words, while ‘machines’ and corporates added exposure, ‘humans’ didn’t.”
Of course that’s not entirely surprising. After all, the vicious media cycle and incessant fearmongering that characterized December left many carbon-based investors shell-shocked. Over the weekend, we talked at length about how fear has become the new cognitive principle, a scenario that contributes to selloffs by creating the perception that anyone who is bearish has special knowledge.
As Marko writes on Monday, the lack of participation from discretionary investors in 2019 “is likely a behavioral reaction to the extreme market volatility and deafening negative coverage in Q4.”
Going forward, Kolanovic believes the market may well “grind higher” and the rationale is familiar.
“Given that systematic investors’ exposure is below historical median levels, and that buybacks should continue this year with the same intensity, it is likely that the market will continue grinding higher”, Marko says.
Of course Kolanovic’s assessment does come with caveats – there are always risks.
One potential stumbling block is the dollar, which is sitting near YTD highs, something we’ve talked at length about over the past week (see here, for example). Additionally, Marko assigns a non-zero chance of the trade deal falling apart.
On trade, Monday brought more of the same in terms of headlines hinting at “progress” and while it seems entirely likely that an agreement is struck in the next two months, this is Trump we’re talking about, so nothing is a sure bet. The inflection in the data out of China and the resiliency of the US economy potentially reduce the urgency around signing a deal, but, again, a “no deal” scenario seems like a tail risk at this juncture.
“We continue to think a US-China agreement will be reached fairly soon and the White House’s apparent aim to reach a preliminary deal by May seems credible”, Goldman wrote Sunday, before warning that there is a possibility of a “sell the news” dynamic taking hold. “Financial markets have already priced in a high probability of an agreement, and we expect that the terms of the deal will not entirely eliminate the uncertainty regarding US-China trade”, the bank wrote, in the same note.
For his part, Kolanovic cautions that “if there is such an idiosyncratic event (e.g. Trump abruptly walking away from the deal, or escalation with Iran causing Hormuz disruptions, etc.), systematic investors would also commence selling equities”, but he reiterates that his base case “is still that the trade deal gets signed, which would put downward pressure on USD and drive further equity inflows and cyclical rotation.”
If you have further questions, just consult your P/L for signs that you’re the worse for not listening to Marko in January.