JPMorgan’s Marko Kolanovic on Monday reiterated his contention that the bubble in low volatility stocks has likely burst or, at the least, is on the verge of doing so.
As bond yields declined over the post-crisis period and central banks persisted in accommodation, investors crowded into bond proxies. As Marko puts it in his latest, “low volatility crowding turned the conventional economics upside down: instead of high-risk stocks leading to higher returns, low-risk stocks consistently produced higher returns”.
The proliferation of smart beta products facilitated factor crowding, blurring the lines between styles, and setting the stage for potentially violent unwinds. September saw just such an event.
When bond yields rebounded off the rock-bottom levels hit in August, one of the most dramatic factor rotations in recent memory played out just below the market surface. That rotation produced a series of multi-standard deviation events which flew under the radar for anyone not willing to “look under the hood”, as it were.
Kolanovic revisits this on Monday.
“Figure 3 below shows the valuation of low volatility and value stocks, illustrating the unprecedented level of divergence (making the tech bubble look like a comparatively modest divergence), and also showing the reversion that started occurring in September”, he writes.
The chart on the right shows “further evidence that reversion is likely to take place”, Marko says.
As a reminder, the plunge in bond yields that defined August was something of a false optic. During a client presentation late that month, JPMorgan’s Josh Younger documented the extent to which fundamentals explained “less than half of the move in rates and inversion of the yield curve”. On his estimates, the rally in bonds was attributable to a “combination of positioning, hedging activity and poor liquidity conditions”.
Marko reiterates that in the context of the unwind in the low vol. bubble.
“The move in bond yields in August (down) was magnified by the trade war escalation, but also by technical moves such as interest rates option hedging, mortgage hedging, insurance liability hedging, CTA crowding into bonds, and momentum crowding and rebalances of equity quants”, he notes, on the way to reminding everyone that those drivers “can also work in reverse, which started happening this September and is likely to continue”.
Given the still massive disconnect illustrated above, Kolanovic thinks it’s probably a good idea to hedge against what he calls a potential “crash” in low volatility stocks. Intuitively, that would entail increasing exposure to value and away from duration and bond proxies. He also flags underweights and outright shorts in cyclicals and the largest CTA short in commodities since 2015.
“The setup for a large squeeze higher in the Energy sector is now increasingly likely”, Marko says, adding that “a decline in the US dollar, progress in the trade war resolution and potential turn in PMIs could increase demand, while various supply problems still exist and may intensify”.
Needless to say, any nods at fiscal stimulus or signs that aggressive easing by central banks is starting to work its way through and manifest itself in better growth outcomes, inflections in manufacturing PMIs and/or higher inflation expectations, could accelerate the rotation away from crowded consensual trades.
Remember, central bank accommodation works on a lag, which means the rate cuts and balance sheet expansion shown in the charts below “should” begin to impact real economic outcomes in the months ahead.