As markets attempt a rebound after one of the more harrowing stretches in recent memory, JPMorgan’s Marko Kolanovic says systematic selling and lackluster liquidity are at least in part to blame for the rout.
“In addition to broad risk-off sentiment from the virus, significant drivers of price action was selling from systematic strategies and option hedgers”, Marko says, in a note out Wednesday, just after lunchtime.
Kolanovic quantifies the impact of the various mechanical flows discussed in these pages over the past several sessions. Specifically, he says option hedging (gamma) likely resulted in $40-50 billion of outflows, while CTAs and vol.-targeting strategies each accounted for ~$40-60 billion in selling, for a total of ~$150 billion.
Dealers turned “significantly short” gamma, Kolanovic notes, on the way to breaking down the market impact. “Selling on account of option hedges was ~$15-20 billion on Monday, and ~$25-30 billion on Tuesday”, he says.
As for the vol.-targeting universe (variable annuities, some risk parity funds, etc.), Marko reiterates that they came into the selloff with relatively high exposure “because bond moves had been offsetting equity moves in the first month of the virus epidemic”.
This week, though, declines in stocks were simply too steep to be completely offset by gains in bonds. And so de-leveraging was in order. Marko estimates that Monday saw ~$30-40 billion of selling, and Tuesday another ~$20 billion from volatility targeters, which he notes “will likely continue selling over the next few days”.
As Nomura’s Charlie McElligott reminded folks on Wednesday morning, selling from vol.-targeters “continues to passively execute in the market… in ‘lagging’ fashion on account of the ‘drag-up’ in trailing realized vol above ‘trigger’ levels”.
The good news is, after this de-leveraging has run its course, that universe will have pared its exposure to just the 35th percentile, on JPMorgan’s estimates. That, in turn, means selling pressure “should ease thereafter”, Kolanovic says.
When it comes to CTAs, Marko estimates they contributed $40-60 billion in selling pressure this week, but doesn’t expect to see further meaningful de-leveraging. “We think CTA selling is now over, as 200d (~3045), 6M (2900) and 12M (2800) signals are not likely being breached, in our view”, he writes, before noting that exposure there has now fallen significantly.
Needless to say, a dearth of liquidity contributed to the selloff. Market depth fell by some 50%, Marko says, conjuring the liquidity-volatility-flows feedback loop that’s a fixture of modern market structure.
It’s important to note that most of these systematic flows work both ways, something Kolanovic reiterates.
“Should there be a move higher, option hedgers would need to buy a significant amount of equities and could prompt a market squeeze higher”, Marko says, adding that a sharp rally could also entail CTAs buying back some of their equity exposure.
Early Wednesday, Nomura noted that the difference between the S&P’s total return this month and the total return on bonds is in the 10th percentile going back more than a decade and a half. That would tend to point to rebalancing flows in favor of equities.
Kolanovic underscores that.
“Our estimates indicate the rebalancing move could produce upside pressure on equities of 1-2%, which could be enough to prompt additional buying from gamma hedgers and CTAs”, he writes.
Obviously, all of the above comes with the obligatory caveats about the virus news not getting materially worse. Marko flatly notes that a “significant” deterioration on that front would probably snuff out any bounce.
And yet, he remains positive on the market as a whole. After all, if policymakers do decide to step in with (more) monetary easing and fiscal measures, they aren’t likely to simply pull it away once the health scare dissipates. As Kolanovic puts it: “The virus should go, but stimulative measures will likely stay”.