“There will be no monthly selling, and indeed there could be buying of equities into month-end,” JPMorgan’s Marko Kolanovic wrote Thursday, amid fairly loud (albeit not shrill) chatter around the prospect of rebalancing flows working against stocks in the very near-term.
For Kolanovic, the standard rebalancing narrative lacks sufficient nuance. He doesn’t put it that way, but his take is more textured than what he described as “broad advertising of some ‘massive month-end selling.'” Investors are “afraid” of that, he wrote, but perhaps they shouldn’t be.
The first thing worth taking account of is the extent to which quarter-end rebalances carry less weight (pun fully intended) than monthly events. “When looking at how many portfolios rebalance using monthly fixed weights versus quarterly fixed (based on their impact on market), we find that fixed weight monthly rebalances are prevalent, while quarter-end rebalances effectively lost meaning and actually result in opposite flows,” Kolanovic said.
The figure (below, from JPMorgan) illustrates the point. Monthly rebalances retain their predictive power, while quarterly rebalances now “show an effect opposite to a rebalance,” Marko noted.
He also mentioned that increasingly, portfolios will rebalance based on volatility targets. That, he said, can lead to flows contrary to those of fixed weights.
Because volatility declined MoM and markedly so QoQ, rebalancing tied to vol targeting could conceivably produce a net inflow. On Kolanovic’s estimates, vol targeting exposure (to equities) sits in just the 20th percentile.
Also on Thursday, Nomura’s Charlie McElligott said that to the extent there is some pension rebalancing supply, it could potentially be “countered by stabilizing flow from the vol control universe, as 1-month trailing realized vol is flattening out again and set to move lower on account of meaningful ‘down days’ dropping out of the one-month lookback window.”
Assuming daily market moves average less than 1% over the next week, Nomura sees “upwards of $25.4 billion of buying” in US equities from vol control. There are some “ifs” in there, but that’s always the case.
For his part, Kolanovic also posited a kind of automatic stabilizer effect (if you will) based on the extreme negative correlation between bond yields and big-cap tech (figure below).
“Over the past two months, we have seen a strong negative correlation between bond yields and the Nasdaq 100,” he wrote, adding that “a rebalance that would buy bonds, in that sense would lead to (discretionary) inflows into yield sensitive equities that would more than offset our current estimate of month-end selling.”
That’s not all. Regular readers will recall that due to the dramatic shift in the market zeitgeist since the election, momentum has lagged significantly. A rebalancing there could mean cyclicals (e.g., energy) get bought too.
And don’t forget about the Russell 2000, which fell into correction territory over the past day or so. Small-caps could see “positive performance… given that the Russell is underperforming bonds month to date,” Kolanovic went on to say.
The bottom line, from Marko, is that market participants should, at the least, be “cautious” about accepting the prevailing narrative on the assumed net effects of rebalancing flows. “The impact on the market may be positive with a near-term upside move,” he said.