The first two appearances by JPM's head quant, Marko Kolanovic, caused a near-panic in the market.
The first time was the Friday before the August 24th flash crash, when as we first reported, he accurately predicted the gamma (un)hedging unwind into the Friday close which sent the market plunging and subsequently morphed into the limit down open on Monday.
The second time was exactly one week ago, when with the market up 450 points, Kolanovic again predicted imminent violent selling, which did indeed materialize not only earlier this week, but within minutes after we posted his note, sending the market tumbling to almost unchanged, before another violent bout of buying pushed it back to the highs in just 30 minutes.
Moments ago Marko came back back with a new note, and unfortunately, once again it isn't pretty.
As a reminder, Kolanovic was the first to explain just how the various "technical" price-insensitive trading strats, which include derivatives hedgers, Trend Following strategies (CTAs), Risk Parity portfolios and Volatility Managed strategies, were incorrectly positioned, and how the residual volatility resulting from either option gamma-hedging or due to any other reason, had become a self-fulfilling prophecy as one after another technical seller emerged and flooded any fundamental buying.
For those confused by all the jargon, we had a brief primer looking at the blow up in "risk parity" funds earlier today: it is a required read for anyone who wants to get to the bottom of the marginal market moving forces at play today.
So what is Kolanovic' update today, and is volatility finally coming down? Not at all.
In a note released moments ago, the head JPM quant says "we have been asked to assess the remaining amount and timeline of these flows and their impact on market price and volatility. In our report, we outlined four groups of strategies: Volatility Target Strategies, CTAs, Risk Parity strategies, and Derivative Hedgers.
Here is his assessment:
- Volatility Targeting (VT) Strategies follow fast signals (such as short term realized volatility) and rebalance quickly (e.g. 1-5 days). Selling pressure from these strategies (estimated to be $50-75Bn) peaked last week and is largely out of the way now. Short-term realized volatility increased from ~10% to ~30%, indicating these funds already reduced their exposure by ~70%. If volatility were to increase further (e.g. in-line with the peak realized volatility in 2011 of ~50%), these funds would have to sell progressively smaller amounts (e.g. an additional ~10-15%). The question is when these funds will start buying. Our view is that the re-levering of these funds is not imminent (e.g. not in the next few days). Leverage in these strategies is a function of trailing volatility (e.g. moving average of the VIX or 1M realized volatility), and even if the VIX were to start declining now, trailing realized volatility would stay elevated for the next ~3 weeks.
- CTAs – Following our report last week, we have been getting questions about CTA equity exposure and the timeline of CTA flows. Our CTA replication models suggested that CTA equity exposure at the end of July was very high, at approximately 30% (or $80-$100Bn notional). This allocation to equities is also consistent with the performance of CTA indices in August (Bonds and Commodities were roughly flat, while Equities were down 8% - thus, a 30% equity allocation would match the -2.5% CTA observed performance). As the trend following signals (e.g. 1M, 3M, 6M, 12M price returns) started turning negative in August, CTAs started de-levering equities (in early August). As of September 1st, our CTA replicator indicates that the strategies should be ~25% short equities (short ~$70bn). This would indicate a ~$150bn swing (selling) of CTAs’ equity allocation.
However, CTA strategies don’t rebalance as quickly as VT strategies, and it often takes 1-4 weeks to achieve their target exposure. To assess where we are in the process of CTA de-leveraging, we have calculated the daily beta of a broad CTA index (HFRXSDV) to the S&P 500 shown in the figure below. Note that the CTA S&P 500 beta dropped from record levels at the beginning of August to zero currently, indicating that CTAs may have completed more than 50% of the expected equity selling (as noted above, target equity exposure is negative ~25%). We estimate that CTAs may continue selling equities for another ~2 weeks, and that the flows may total ~$40-$60bn. Once CTAs establish their September 1st target positions (short equities), they will no longer be selling, and risk becomes skewed towards CTAs buying equities. We estimate CTA flows in other asset classes include a reduction of USD exposure (from $40bn to zero), no change in bond positions, and some short covering of Oil and Gold (from short 40bn to short 30bn).
- Risk Parity (RP) –We studied this allocation method in our Primer on Systematic Strategies, and argued that it is one of the soundest approaches to managing portfolio risk.
Risk Parity strategies de-lever when asset volatility and correlation increase. In our report last week, we estimated that risk parity outflows from equities may total $50-100bn on account of the increase in market volatility and risky asset correlations. These rebalances have started, but, given their typically slower rebalance frequency (e.g. monthly), are largely incomplete. We believe the bulk of the risk parity flows are yet to come, and this may add selling pressure to equities over the next 1-3 weeks. To illustrate this point, one can look at a sample multi-asset Risk Parity strategy such as the Salient Risk Parity index. The beta of this index to the S&P 500 (shown in the figure above) reached highs of 60% in early August, and has dropped to about 45% currently (compared to a beta of 0% during some of the previous episodes of market volatility).
Please note that in our estimate of Risk Parity assets we have included funds that use Risk Parity as a risk management overlay and tactical allocation, and not just the dedicated Risk Parity (Quant) hedge funds. One could perhaps even broaden the definition of Risk Parity funds to include investors that change their strategic allocation based on expected volatility (e.g. such as CalSTRS announcement of plans to reduce equity exposure in the near future, recently reported in the media).
His take home assessment: only half the selling is done, and another $100 billion remains over the next 1-3 weeks:
In summary, we estimate that only about half (or slightly more than half) of total technical selling was completed to-date (mostly completed by VT funds, half by CTAs, and a smaller fraction by RPs). We estimate that a further ~$100bn of selling remains to be completed over the next 1-3 weeks. As a result, we expect elevated volatility and downside price risk to persist. In our view, the risk/reward for equity investors remains in favor of waiting, rather than being fully invested until there is more clarity from macro data and central banks.
The problem is that since this is a self-reinforcing loops, the more selling there is, the more selling there will be unless some central bank forcefully intervenes. Draghi tried earlier today, but it was not enough.
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Finally, anyone still confused about the infamous 3:30pm ramp (or recently tumble) phenomenon, the answer is simple: all gamma hedging:
Gamma hedging of options, levered ETFs, variance swaps and other convex products continues to be a significant driver of price action near the market close. As we predicted in our note on Friday, the typical impact is during market down days (and is causing an acceleration of market moves from ~3:30PM to the close). Note that the impact of gamma hedging may also push the market higher (if the market is up from the previous close). For instance, on September 2nd gamma hedging likely helped squeeze the market higher into the close (figure left). We have also noticed that gamma hedgers are moving their hedging activity earlier in the day in an attempt to avoid losses. There is also a strong possibility that option hedging flows are being anticipated by speculators. This can lead to price patterns in which intraday momentum happens earlier in the day, briefly reverses as speculators exit their positions, and finally reappears at the market close as hedgers with no flexibility execute at the close (e.g. levered ETFs or var swap/put basis that often has to be done MOC). Gamma positioning of S&P 500 options remains tilted towards puts, and we expect upward pressure on realized volatility from gamma hedgers to continue over the coming weeks.