“By just looking at the price of the S&P 500 – not far from all-time highs – one cannot see the true state of equity markets”, JPMorgan’s Marko Kolanovic writes on Tuesday, weighing in on the outlook amid a historic unwind in consensual positioning that saw Momentum routed in favor of Value to start the week, despite muted moves at the index level.
“Most of the S&P 500 gains came from defensive sectors, stocks that investors tend to buy as a proxy for long duration bonds, and so-called ‘secular growth’ technology stocks”, he goes on to write.
The nascent bond selloff which saw 10-year yields in the US rise another 8bps to 1.73% on Tuesday, has rippled across stocks, weighing on consensus positioning which, in many cases, is just a reflection of the duration trade in rates. So, long secular Growth and Min. Vol., against short Cyclicals.
On Monday morning, we noted that this has come up time and again over the last several months. In that context, we mentioned that Kolanovic discussed it a few notes back, something he reminds folks in his latest.
“In July, we wrote how the underperformance of value stocks relative to low volatility and momentum stocks is worse than any historical factor divergence, including during the late ’90s tech bubble”, he reiterates. For anyone who missed the chart he used, here it is:
Suffice to say that turned around in dramatic fashion on Monday.
Marko flags another “all-time extreme divergence”, which he says showed up on Friday in the form of a “record performance gap between small and large companies”. Specifically, he says a momentum indicator of small-caps hit “its maximal negative reading” while the same indicator for the S&P touched “its maximal positive reading”.
This all speaks to the same general story, namely that headed into this month, there was an epic divergence that was bound to snap back at some point. “Many similar indicators suggest the gap is not sustainable between value, cyclicals, SMid and high beta stocks on one side, and momentum, low volatility, and growth on the other side”, Marko says, before noting that Monday brought “a ~5 standard deviation rally of value versus momentum”.
Here’s a snapshot of various factors which underscores the point (as Nomura’s Charlie McElligott emphasized, what you want to look at is the one-day z-score column to truly appreciate the scope of the move):
The question now is whether the rotation is sustainable.
To answer that, Marko first takes a lay of the proverbial land, touching on several of the points we’ve discussed here over the past couple of weeks. As trailing realized vol. moves lower, it should lead to re-leveraging from systematic strats. Kolanovic notes that CTAs’ equity beta is sitting in just the ~20th percentile, while exposure for the vol.-targeting crowd is low too, in just its ~25th percentile. He also notes that dealers’ gamma positioning is in the “shock absorber” zone, if you will, as “index option convexity is now long, further suppressing realized volatility”. Throw in buybacks ahead of the Q3 earnings blackout, and you’ve got a strong case for near-term upside
Hedge funds’ beta to equities sits in just the 2nd percentile, while that for Long/Short funds is in just the 1st percentile. Here’s the annotated chart from Nomura we used earlier this week (note that this is easy to recreate yourself using the rolling beta function on BBG with the HFRX indices, but this one is colorful, and thus a crowd pleaser):
Marko flags the myriad geopolitical powder kegs in play, many of which have taken a turn for the better. For example, investors are now predisposed to taking a glass-half-full approach to upcoming principal-level talks between China and the US, Italy has averted a hostile takeover by Matteo Salvini and the odds of a hard Brexit have receded considerably, at least for the next few months.
But irrespective of how those stories develop, Kolanovic says there’s “a 3-week window in September where the market can move higher from record low positioning”. The following, from Marko, will sound familiar to regular readers:
How would an increase of equity positioning look? We first note that while net equity positioning is near lows, gross exposure of hedge funds is very high (for instance, JPM’s Prime Brokerage portfolio shows gross leverage in its 99th percentile since Jan’18). Given record high gross and near record low net exposure, the most likely way to increase exposure is by closing shorts. This is the type of move that we saw yesterday and we think it has a lot of room to continue. Closing shorts would push value, cyclicals, high volatility, and small caps to outperform the broad index. Momentum and defensives would lag. In fact, we think that [Monday’s] move was only started by discretionary PMs, and will continue with equity quants (that typically operate at lower frequency, e.g. month-end) and fundamental investors.
There you go – some additional context and forward-looking color on the violent rotations that saw beaten-down laggards and unloved corners of the market rip against the wholesale “puke” in consensus longs.
What about beyond the near term? Is a rotation to Value sustainable? Maybe. It all depends, as ever, on the evolution of the macro backdrop, which is itself contingent on expectations for stimulus, both monetary and especially fiscal.
“We think that it’s quite possible [to see a more sustained value and broader market rally beyond October] given the recent increase of monetary and fiscal stimulus globally that typically acts with a delay”, Kolanovic writes. Consider the following chart, which plots China’s credit impulse and the central bank “cuts versus hikes” line (both on a lead) with the global manufacturing PMI:
That’s why Marko thinks there’s room for some optimism.
“While manufacturing lags both, we see that in the coming months one could expect manufacturing activity to pick up given the increased monetary stimulus, providing support for the market and value stocks”, he says.
Of course, a lot of this hinges on how discussions between Bob Lighthizer, Steve Mnuchin and Liu He develop next month. On that, Marko reiterates that Trump is playing with fire ahead of an election year. As we’ve been keen to point out, recent polls clearly indicate that voters are concerned about a recession and are increasingly predisposed to viewing Trump’s economic policies as harmful.
“A recession going into election would be politically devastating, and with the time window to the election closing, it would be reasonable to expect some progress on trade”, Marko says, adding that if such progress materializes, it “could give enough time for monetary and fiscal measures to turn around economic activity”.