On Monday morning, as market participants rushed to assess the implications of the largest crude oil supply shock in history (and the biggest intraday jump in Brent on record), we excerpted a few passages from the latest by Nomura’s Charlie McElligott.
Putting the oil shock in the context of last week’s Momentum unwind, Charlie noted that while “a re-rallying of ‘risk-off’ trades would help stanch the bleeding in the US Equities factor rotations, particularly the ‘Momentum Massacre’”, any concurrent rally in energy names could be a “point of pain”.
Why? Simple. Because energy shares “have acted as ‘placeholder shorts’ for HFs [and] baseline underweights for MFs for years”. “Even despite September’s +6.1% rally on the Momentum unwind, the sector remains -18.0% as the S&P’s worst over the past 1Y”, McElligott wrote.
Fast forward a few hours and JPMorgan’s Marko Kolanovic is out with an expansive take that touches on that dynamic and much more.
“The extreme divergence between value stocks on one side and low volatility and momentum stocks on the other side reached levels never observed in history, even including the tech bubble”, Marko reminds you, recapping a point he’s been pounding the table on for months.
On Monday, Marko goes so far as to call this the next “XIV”, a reference to the infamous VIX ETN “extinction event” on February 5, 2018. He explains as follows:
In fact, crowding in this trade reached levels that will ultimately make it another “XIV” (short VIX) trade. What is the similarity with the “XIV” trade? Recall that selling volatility was a trade that worked well for a long time. The more money that went into selling volatility, the better it worked via direct suppression of implied volatility and feedback loop suppression of realized volatility via long gamma overhang. With low margin requirements and tail risk not properly captured by many risk management systems, investors were able to lever to levels that eventually led to a wipeout once forced closing started.
Kolanovic goes on to remind you that following “Vol-pocalypse”, “risk aversion towards long delta and short volatility increased drastically, which made this trade hard to implement”.
But something else came along, as it always does. In this case, the long Momentum/ short Value trade.
Well, as we’ve spilled gallons upon gallons of digital ink discussing in these pages (including in the linked post above), that trade involved, in many cases, shorting energy. Marko delves into this in his Monday missive.
“This was implemented in directional sector plays such as long software, short smid oil and natural gas stocks”, he writes, adding that “many platform risk management systems don’t have a good ability to capture factor risk, and hence it was possible for PMs to implement these long-short trades with very high leverage”.
(The SPDR S&P Oil & Gas Exploration & Production ETF was on track for one of its best days ever on Monday)
As we saw last week, this trade was extremely crowded and very vulnerable to a reversal given a macro catalyst. That catalyst ended up being the duration selloff which accompanied a string of reasonably positive economic data in the US and renewed trade optimism, which together catalyzed a rapid backup in long-end yields.
That, in turn, rippled across consensual positioning in equities, where laggards like cyclicals and Value exploded higher, while consensus “slow-flation” (if you will) plays were unwound in dramatic fashion.
Now, the oil shock has taken the baton in terms of serving as the macro catalyst for a continued unwind. Or at least that’s the potential setup.
“These trades worked well until the rotation started, and now are in the early stages of a collapse”, Kolanovic warns, before noting that if you ask him, the unwind is just getting started, “as evidenced by equity PMs continuing to fight the value rotation towards oil and natural gas sector every day last week”. He cites rallies at the open, followed shortly by weakness.
Now, the oil spike is set to exacerbate things meaningfully. “The recent spike in Oil will just accelerate this unwind and eventually lead to a capitulation of the short value/beta trade”, Marko says.