Two weeks ago, we reported that an odd, if familiar, decoupling had re-emerged in the market where following the torrid rebound in the market, carbon-based traders (also known as humans) and fundamental hedge funds, have been skeptical of the rally and unwilling to chase stocks higher, were in fact selling stocks, while the strong upward momentum in risk was just the catalyst to turn technical investors, CTAs and other momentum-chasing machines and robots bullish. As a result, we noted that a situation had emerged where "Record Human Hedge Fund Selling Meets Furious Robot CTAs Buying", a divergence where for now, at least, the machines are winning.
To be sure, this wasn't the first time we had seen such a temporary decoupling: in late July 2019, we wrote that "An Unprecedented Market Divergence: Robots Are All In Stocks As Humans Flee", which however last only a few days before a violent quant snapback slammed stocks, while the ensuing repo crash in Sept 2019 forced the Fed to step in with "Not QE" to bailout markets and hedge funds. In short, the humans were right, and it was only more Fed bailouts - which ended up with Powell eventually nationalizing the entire market - that prevented a historic crash.
Fast forward to today, when more strategists are starting to notice that the market euphoria in recent days has been almost entirely due to algos and robots.
As Nomura's Masanari Takada writes overnight, global equity markets extended their gains yesterday, briefly pushing the S&P above 2,900 as governments and central banks around the world have been taking bold steps to prop up national economies, and with more and more observations being made to the effect that the coronavirus pandemic has passed its peak, investors are probably finding it an unappealing time to enter into bearish trades: "barring some unexpected market-negative news, conditions look conducive to a spontaneous recovery in investor confidence", Takada writes.
However, as the Nomura quant next adds, and seemingly echoing what we first said in mid-April, "the buying of equities we are seeing has a strongly technical flavor, as it is apparently being led by trend-following algos (CTAs, risk-parity funds), including by way of short-covering."
And, as we also noted two weeks ago, while "machines may be getting back into the market, human investors appear to be taking their time. With human market participants staying at home (both literally and figuratively), the machines have proceeded on their own to systematically buy up equities."
Within the realm of machines, one notable buyer is the risk-parity industry, which after getting crushed at the start of March is starting to dip its toe back in, and according to Nomura, "risk-parity funds appear to have slightly upped their allocations to DM equities and EM equities in the context of their month-end rebalancing, and have been buying equities accordingly." This is happening sooner than Takada had expected, given that equity market volatility is still high. However, as the Nomura trader suggests, it is best to assume that risk-parity funds are buying equities simply as the default alternative to the high-yield bonds they have been selling. The portfolio weights that risk-parity funds are assigning to high-yield bonds are now down to their lowest levels since 2013, so risk-parity funds’ buying of equities (for lack of a better alternative to high-yield bonds) looks likely to take a breather soon.
Meanwhile, echoing what his co-worker Charlie McElligott said earlier, Takada notes that trend-chasing CTAs are also dipping their toes into chasing US equity futures markets up. And similar to Charlie, who earlier said that CTAs will turn 100% bullish if the S&P closes above 2,901, Takada estimates that CTAs have swung net long in S&P 500 futures and have just finished closing out their short positions in Russell 2000 futures. The rally staged by the Russell 2000 yesterday (27 April) presumably pulled CTAs into a short squeeze.
Besides the return of trend-followers in the US, CTAs appear to be taking an early bite out of anticipated rebound in European equities. According to Nomura, the supply-demand dynamics among CTAs look much the same in European equity markets, as CTAs are now either square or slightly net long in most EMEA equity futures markets. At this point, FTSE 100 futures, IBEX 25 futures, and RTS futures are the only EMEA equity futures markets in which CTAs are still net short.
Meanwhile in Germany, CTAs are now clearly tilted net long in DAX futures, even if this net long position looks divorced from economic fundamentals. Considering the downward trajectory of the Ifo Business Climate Index, Takada cautions that "what we are seeing is arguably a classic bear market rally."
In parting, we will note that many have pointed out the sharp drop in market volumes in recent weeks. Nomura also highlights this, saying that liquidity in equity futures markets in general has yet to truly recover.
In other words, even the smallest buying intentions now have an outside impact on the market, with conditions such that "a flow of orders in the same direction can upset the balance of supply and demand and thereby cause wide price swings."
As Takada concludes, while it is true that there is "increasing talk of resuming economic activity in Germany and other major economies in the region, trend-following algos, by getting in early, have already eaten into some of the potential for a stock market reversal associated with such a resumption of economic activity."