Marko Kolanovic: Unless There’s An External Volatility Shock, Equity Exposure To Increase

Earlier this year, when many market participants were convinced that the economic apocalypse was nigh and that stocks should be trading accordingly, JPMorgan’s Marko Kolanovic very calmly explained that, despite being dismayed at the extent to which a variety of factors conspired to deep-six confidence during the December rout, the S&P had a date with 3,000.

At the time, some commentators of a cynical persuasion, and even some mainstream financial outlets, adopted a somewhat derisive tone towards Marko’s unwillingness to concede that equities wouldn’t likely summit new peaks any time soon.

Fast forward a mere six months and stocks have, in fact, made numerous new highs. In recent notes, Kolanovic has been generally charitable when it comes to pointing out the fact that, in the final analysis, he was right and a lot of other people were demonstrably, unequivocally wrong.

When last we checked in on Kolanovic, he was busy warning that the costs of the trade war were “100X” the tariffs collected. He also noted that the political ramifications for Trump of pushing the US economy over a cliff by perpetuating the trade war would not be good. On June 12, when investors were still shaky after an abysmal May (the only bad month of the year for equities), Marko retained a cautiously positive outlook. “As a strong market and avoiding a recession would boost re-election odds, it would only be rational to expect this outcome”, he wrote.

Fast forward to July and, with stocks parked near fresh record highs, Marko is back and the first order of business is to remind you that the S&P has already hit his target – right on time.

“Earlier this year we forecasted that the S&P 500 could reach 3,000 by late spring”, he writes. After detailing the factors that went into that call (which we’ve been over in dozens of previous posts), Kolanovic flatly notes that with the Fed “having indicated that it will cut rates and after the June G20 détente, the S&P 500 resumed its rise and reached our target in early July”.

So, what’s next? Well, Marko points out what’s intuitive, which is that the recent run-up has left positioning less favorable, where that just means exposure isn’t as low as it was. “In particular, the equity beta of all hedge funds increased to ~60th historical percentile [but] equity long-short investors still have relatively low exposure, in their ~30th percentile, despite running high gross exposure”, he writes, adding that “given the decline in volatility and positive momentum, systematic funds have above average exposure, with volatility targeting funds ~55 th percentile, and trend followers (CTA) ~70th percentile”.

(JPMorgan)

Does this mean there’s limited scope for further re-leveraging? Yes and no. Obviously, some of the recovery in positioning has now played out, but that doesn’t mean it can’t continue.

“Once exposure starts to increase, it tends to continue until there is an external volatility shock”, Marko says, on the way to noting that last year, positioning recovered from basically zero to near the ~100th percentile by September. That was only short-circuited by Jerome Powell’s “long way from neutral” communications misstep.

Describing some of the other episodes marked in green in the figure, Kolanovic writes that “in 2016, positioning increased from ~0 in February to ~100th percentile at the end of the year, and stayed near max long for the next 14 months”.

Re-leveraging/re-risking is not necessarily an impediment to further re-risking – in fact, given momentum and where things currently stand, it seems at least as likely that systematic flows continue to push things higher.

What about stability? That is, how vulnerable is this situation to the kind of harrowing, selling-begets-selling spirals that played out on a number of occasions in 2018?

The good news there is that, as Marko goes on to say, “current dealer positioning in options makes them heavily long gamma (e.g. call — put gamma exposure is over $40bn per 1%)”, which, in short, means dealer positioning will likely keep a lid on volatility, at a time (summer) when vol. would be seasonally low anyway.

While Marko admits that “the positioning argument is not as strong as it was earlier this spring” (as alluded to above), he writes that “the suppression of volatility during the summer is more likely to support equities moving higher”. JPMorgan’s new S&P target is 3,200.