Yesterday when we presented Tom DeMark's latest technical forecast, which anticipates a 5-8% bounce in risk before the next leg lower in equities, we said to "look for the next few days to see if DeMark still has his magic" adding that "we, on the other hand, would rather wait for "Gandalf" Kolanovic' next take."
We didn't have long to wait: moments ago JPM's head quant, whose uncanny track record of predicting every major market inflection point has been duly documented here, laid out his latest thoughts on the negative feedback loop that is "becoming a significant risk for the S&P 500" but also showed what he thinks is an odd divergence between various asset classes, to wit: "as some assets are near the top and others near the bottom of their historical ranges, we are obviously not experiencing an asset bubble of all risky assets, but rather a bubble in relative performance: we call it a Macro-Momentum bubble."
His warning: beware the bursting of the macro-momentum bubble.
Here is the latest warning from the man whose every single caution so far has played out virtually as predicted:
Macro Momentum Bubble
In our report last week, we argued that the chance of a bear market is much higher than the market expectation at the time (our estimate ~50% vs. options implying ~25%) and recommended increasing allocations to gold and cash. Over the past week, S&P 500 took another leg lower—and now we believe the market prices a ~50% probability of a bear market. While systematic strategies de-levered more than 2/3 of their exposure (as compared to August/September), market sentiment remains bleak, and there is no obvious catalyst to drive market higher. Short option positions increase market volatility and intraday market moves. The large S&P 500 intraday selloff yesterday was likely driven by gamma hedging (there’s a large put-call gamma imbalance of $25bn per 1%). As we wrote in our report last week, significant short gamma positions are in the 1950-1800 range, and decline below 1800 (on account of put-spreads, where clients are short lower strike puts). As the market fell close to 1800 yesterday, declining gamma near 1800 could have contributed to the sharp intraday reversal.
That was then, and played out just as Kolanovic predicted: here is the latest warning:
At this point we think that the negative feedback loop between market performance, volatility and the real economy (wealth effect) is becoming a significant risk for the S&P 500. To stabilize equities one would need a strong catalyst such as the Fed turning significantly more dovish (or even launching another round of easing). This could put the dollar rally into reverse, stabilize commodity prices and put a floor under the S&P 500. The S&P 500 selloff may also be the catalyst for a momentum– value convergence, which we advocated in our 2016 Outlook (e.g., Oil – Equity convergence).
Going into 2016, many investors were wondering if the monetary easing over the past 7 years inflated a bubble in risky asset prices. The answer to this question depends on which risky asset one looks at. In fact, while some assets are near their peaks of historical price and valuation levels, others are near their lows. Since the last bear market 7 years ago, the S&P 500 is up ~200% and still near all-time high levels. The US Dollar Index (DXY) is also at its highest point in 15 years (since the tech bubble). On the other hand, a large number of risky assets are in the opposite situation: Emerging Market equities, EM Currencies, Commodities are currently trading below levels during great recession of 2008/2009. This unprecedented divergence (more than ~3 standard deviations) is shown in the figure below (also see our 2016 Outlook). Figure 1 shows price of several Momentum assets (S&P 500, S&P 500 Low Volatility Index, S&P 500 Software Index), and Value Assets (EM Currencies – JPM EM FX Index, MSCI Latin America Equities and Commodities – BCOM Index). The left Figure below illustrates that since the onset of the 2008 crisis, the price of Momentum assets increased to 500%, 600%, or even 700% as expressed in units of Commodity prices (BCOM Index, and we observe a similar appreciation in units of EM FX or EM Equities). In summary, as some assets are near the top and others near the bottom of their historical ranges, we are obviously not experiencing an asset bubble of all risky assets, but rather a bubble in relative performance: we call it a Macro-Momentum bubble.
Why do we have this bubble?
Every asset trend starts with fundamental developments. As the US was the first to get out of the global financial crises of 2008-2011 (with Europe and Asia lagging), US assets such as the S&P 500 and USD started outperforming international assets. Divergence between Central Bank policies triggered the USD rally, cross-regional capital flows, and put pressure on EM economies, Commodity prices and Commodity related Developed Market Equity sectors. However, we think that fundamentals were only one of the drivers, and that structural reasons played an equally important (or bigger) role in the creation of this relative performance bubble. These structural drivers are listed and explained below.
Diagram above right shows a hypothetical performance of 2 assets: one with positive momentum and another asset whose price declined below some long-term valuation level. As the price of the trending asset increases, its volatility declines. Similarly, the volatility of the ‘value’ asset increases as the price moves lower. Based on this pattern, most risk models would increase the weight of the trending asset and decrease the weight of the value asset, reinforcing the divergence. Many systematic strategies (such as CTAs, Risk Parity/Vol Target, Low-vol Risk factor portfolios) would do the same. The positive feedback between inflows and low volatility eventually increases the crash risk for trending assets.
We think S&P 500 momentum turning negative this year (after a 6-year rally) may be the first step of the mean reversion we expect to play out later this year. Mean reversion would lead to the outperformance of Emerging Market stocks, Commodities, Gold, and the Energy Sector, and relative underperformance of Momentum assets such as USD, S&P 500 Low Volatility and Momentum portfolios, and likely the S&P 500 itself.
Below we list and explain several structural factors that led to Macro-Momentum bubble:
Explicit Trend Following Strategies: Assets in strategies that explicitly follow price momentum experienced double digit growth over the past few years, and currently stand at over $350bn. This includes CTAs, but also in-house managed pension assets, dealers’ structured products, etc.
Implicit Trend Following Strategies: Many systematic strategies bias towards momentum assets. Historically, assets with strong trends exhibit lower volatility and lower correlation to other assets, and are over-weighted in risk budgeting frameworks such as Risk Parity and Volatility Control. In addition, Low Volatility/Smart Beta strategies often overlap with Momentum investing. Over the past year we saw a significant increase in these assets, with the asset base likely topping $1Tr.
Macro HF bets are aligned with Momentum bets: Over the past years, many popular macro trades (long USD, short Oil and Gold, long DM and short EM equities) are closely aligned with simple trend following signals. The more recent trades betting on HY defaults or breakdowns in EM currency pegs, also align with recent price momentum (USD up, Oil down, etc.)
Volatility based risk management: Many risk management tools refer to historical covariances to determine asset allocation. This approach prefers momentum assets (that have lower volatility and average correlation) over value assets.
Decrease of active assets and increase of passive assets: Active equity managers tend to have a value bias, while capitalization based passive indices tend to have a momentum bias (e.g., they increase the weight of stocks that outperform). The shift from active (e.g., seen from persistent mutual fund outflows) to passive assets (particularly ETFs) may have contributed to the underperformance of value and outperformance of momentum in equity long-short portfolios.
Higher cost of capital for Value assets: Value trades require more capital than Momentum. Given higher volatility, value assets tie up more risk capital for longer periods of time (momentum tends to work on shorter time horizons, and value/reversion on longer time horizons).
Lower liquidity of Value assets: Value assets, being more volatile than momentum assets are also less liquid. Since financial crisis, both investors and market makers are averse to hold and provide liquidity of less liquid assets.
So now we know that we have not one massive bubble, but a bubble of small asset-class divergences, all thanks to the Fed. What to do? As a reminder, here is how JPM's will trade this: use transitory bounces to liquidate risk positions, and stay in either cash or gold until better buying opportunities present themselves.
Unless, of course, Yellen launches QE4, in which case all bets are off.