JPMorgan Asks: Is This The January 2018 Melt-Up All Over Again?

At various intervals over the past two weeks, we (and plenty of others) have conjured the post-tax-cut melt-up in January of 2018 to describe the state of the US equity market.

That’s not necessarily an attempt to “get bearish”, as it were. Rather, it’s just an observation.

Obviously, not all indicators will validate that comparison, but it’s not hard to create scary-looking visuals. Here, look:

And we could generate a dozen others.

In the latest edition of the bank’s popular “Flows & Liquidity” series, JPMorgan takes a look at precisely this comparison (i.e., between now and January of 2018) and comes to broadly similar conclusions – namely that there are signs of “overextension”, even if that doesn’t necessarily presage any kind of rout.

The bank’s Nikolaos Panigirtzoglou notes that institutional investors continued to ramp up their exposure at year end. “These positions had risen steeply last year, propelling the equity market during the course of 2019, with an additional steep increase in December”, he writes, adding that “as a result, these spec positions on US equity futures stand at even higher levels than the beginning of 2018”.

(JPMorgan)

Meanwhile, short interest on SPY recently declined to levels consistent with the lows in 2018.

Now, recall that over the weekend, we talked a bit about hedge fund underperformance. One of the things we mentioned was that there was a mad dash for beta in Q4 among Morgan Stanley’s fund clients.

Panigirtzoglou underscores this. The Long/Short crowd’s beta “increased sharply during November and December”, he says, noting that when you take a look at monthly reporting Equity Long/Short hedge funds, “their beta to the MSCI AC World index stood at 0.53 in October 2019”. That’s close to the historical average. Then, as the broad market began to run, their beta rose rapidly to 0.65 in November and 0.76 in December, which JPMorgan remarks is indicative of “a significant OW position. Indeed, if you look at the December 2019 beta of 0.76, it’s “close to the 0.81 beta seen in December 2017”, Panigirtzoglou observes.

What about CTAs? After all, trend de-leveraging has been at the core of some of the worst meltdowns we’ve seen over the past couple of years.

On that score, Panigirtzoglou writes that while the average z-score of the short and long look-back period momentum signals for equity futures is elevated at +1.0stdev versus nearly +1.5stdevs headed into the end of January 2018 (i.e., just prior to the correction), grievous cross-asset de-leveraging is less of a risk from the momentum crowd – or at least on his framework.

(JPMorgan)

In January of 2018, “not only had momentum signals reached extreme territory across all major equity futures but also across a wide range of asset classes ranging from the euro to oil prices to the 10y UST”, he says. That, in turn, set the stage for momentum strats to get shelled across a variety of positions, causing forced exits and massive losses across a 4-day span in February of 2018, when the VIX ETNs blew up.

All in all, Panigirtzoglou’s broad strokes conclusion is this:

Speculative institutional investors increased their equity exposures significantly over the past two months, implying that their current equity exposures are not far from their previous January 2018 levels. As a result, equity markets, particularly US equity markets, look vulnerable to negative surprises… For this position vulnerability to manifest itself into an equity correction a trigger is required, such as a progressive candidate winning the Iowa primary on Feb 3rd or a significant negative macro surprise, rather than solely caused by position driven momentum reversal similar to that seen in February 2018. 

That latter bit is important. The February 2018 rout was primarily attributable to a cascading, systematic unwind triggered initially by the realization of the rebalancing risk across the universe of levered and inverse VIX ETPs. Because volatility “is the toggle by which positions are grown or reduced” (to quote Nomura’s Charlie McElligott), the massive VIX spike triggered waves of de-leveraging.

There is no such setup now, so even in the event there were a catalyst that starts tipping dominoes, the collapse of the Jenga tower (to mix game night metaphors) likely wouldn’t be as severe.

Fingers crossed on that – especially for anyone buying big-cap tech at ~23X…

(Bloomberg)