Kolanovic Says Stocks May Soar 7% Next Week

Could rebalancing flows help US stocks log their largest weekly gain since November of 2020?

Maybe, according to JPMorgan’s Marko Kolanovic, who, on Friday, noted that although rebalances aren’t typically the main driver of markets, they can take on outsized significance following one-way price action. The dynamic can be even more pronounced when rebalancing flows hit in low-liquidity environments.

“Next week’s rebalance is important since equity markets were down significantly over the past month, quarter and six-month time periods (hence the various rebalance frequencies reinforce each other), and it is happening in a period of low liquidity,” Kolanovic said, in a new note.

Perhaps the most poignant recent example of this occurred in late December 2018 when US equities trimmed some of that month’s steep, Fed- / government shutdown-inspired losses in a dramatic post-Christmas rally (figure below).

The gains (in green) were widely attributed to a rebalancing bid for stocks after a truly harrowing rout.

Kolanovic flagged rallies in late March and May (purple in the figure, below) as evidence of the impact of rebalancing flows in 2022, on the way to describing the setup for next week.

“Broad equities are down 21% for the year (9% versus bonds), 16% for the quarter (11% versus bonds) and 9% for the month (7% versus bonds),” he wrote. “Rebalances across all three lookback windows would reinforce and, based on historical regression, would imply a ~7% move up in equities next week.”

Those flows could be magnified by impaired market depth. Liquidity is five times lower than the historical average, Kolanovic noted. That means it takes less to move the market.

At the same time, positioning remans very light across virtually all key investor cohorts and cash balances are now very high. “Any up move would also be reinforced by CTA and option gamma hedging flows,” Marko went on to say.

He added an obligatory caveat: “Rebalances are not the only drivers and the estimated move is assuming ‘all else equal.'”