“Many investors did not participate in the equity rally”, JPMorgan’s Marko Kolanovic writes, in a new note out Wednesday.
That’s a familiar argument. Talk of “real McCoy” bubbles and Robinhood manias notwithstanding, the fact is, positioning across key investor cohorts remained noticeably subdued over the course of the surge from the March lows, and equity fund flows have been similarly somnolent.
“Low positioning is a result of high macro uncertainty and market volatility”, Kolanovic says, before providing a quick update on positioning. “For example, hedge funds’ equity beta index is in its ~10th percentile [and] quantitative funds have similarly low exposure because of high volatility”, he writes. CTAs’ positioning is in just the ~20th percentile, while volatility targeting and risk parity still register in just the ~5th percentile.
CTA re-leveraging and incremental buying from the vol-control universe (as realized volatility declines) have served as a catalyst recently. “This matters when discussing ‘incremental buyers’ who are unemotional and take no explicit view on COVID case-growth, versus many discretionary traders who are rationally struggling with the fundamental backdrop and outstanding risks to sentiment”, Nomura’s Charlie McElligott said late last week.
As long as volatility stays well-behaved (and, ideally, grinds lower), this unemotional, mechanical short-covering/re-leveraging can continue.
Kolanovic underscores the point. “If macro and market volatility can decline, these investors will be pulled into the market”, he says, on the way to noting that if these cohorts were to reach even their historical median, it would entail adding some ~$400 billion of equity exposure. That would “easily” propel stocks to new highs, Marko notes.
From a 30,000-foot perspective, he reminds you not to lose track of the fact that vast sums are invested in multi-asset strategies. So, it’s not as simple as pointing to elevated P/E ratios and saying “See, stocks are expensive”. Rather, it’s all relative — especially these days.
“Based on ERP, equities were cheaper versus bonds only ~15% of the time historically”, he writes, in the course of patiently explaining that this is not some nebulous theory, but rather a concrete reality. “Relative bond-equity valuation is not just a theoretical framework — there are real flows that come with it”, he says, citing pension funds shifting their allocations to hit long-term return requirements.
He also touches briefly on the dynamics discussed here Wednesday regarding the extent to which the market’s jitters about the outlook for growth are manifesting in record highs (and stretched valuations) for secular growth.
“Crowding in these stocks indeed reached elevated levels [and] this is in part the result of long-short trades where portfolio managers are buying mega-cap tech and momentum stocks while shorting smaller cyclical and value stocks”, Kolanovic reminds you, adding that the rationale is simply that the world won’t be the same after the pandemic.
He also flags expectations for a Joe Biden victory in November as a contributing factor to the caution embedded in the character of the rally.
For Kolanovic, the market has it wrong — or at least market participants have mispriced the recovery and, quite possibly, the election.
On the virus, Marko writes the following:
Despite the 6-fold increase in cases in TX, CA, AZ, and FL, mortality so far increased by about ~25%. By looking at real-time influenza-like illness (ILI) in these states, we observe that the increase in influenza-like symptoms is quite a bit smaller than what was observed in March/April (also true when adjusted for expected seasonal incidence), indicating that the affected demographic is likely showing less severe symptoms.
That said, he does caution that “the large increase in cases is expected to result in some additional uptick in mortality as well”.
When it comes to the election, Kolanovic reiterates the relatively benign take from the bank’s recent assessment of a possible Biden victory. “There is no large difference between Trump and Biden when it comes to the overall impact on equity markets”, Marko says, noting that the fallout will be felt at the sector-level instead.
His colleague Dubravko Lakos-Bujas expressed similar sentiments this week. “The consensus view is that a Democrat victory in November will be a negative for equities [but] we see this outcome as neutral to a slight positive”, he wrote.
The chart (below) uses JPMorgan’s figures for the expected impact on 2021 S&P EPS from a Biden presidency, including estimates for a deescalation of the trade conflict.
Ultimately, Kolanovic’s answer to the question “Can the recent equity rally continue?” is “yes”, although he does see scope for “a repricing” of recent trends which have driven mega-cap tech and secular growth to record highs at the expense of cyclicals, high beta, and value.
That repricing, if it occurs, “could result in a rapid momentum selloff and value rally”, he says.
Shortly after the pandemic triggered one of the fastest bear markets in recorded history, Kolanovic predicted US equities would return to record highs by 2021.
The Nasdaq summitted new peaks just two months later, while the S&P is within striking distance.