JPM's "Gandalf" Quant Is Back With A Startling Warning

Two days ago we reported that one half of JPM's Croatian "Duo of Doom", namely equity strategist Mislav Matejka, became every BTFDer's worst enemy when he said that the time of BTFDing is over, and a regime change has arrived one in which rallies are to be sold. To wit:

Our view is that the risk-reward for equities has worsened materially. In contrast to the past 7 years, when we advocated using the dips as buying opportunities, we believe the regime has transitioned to one of selling any rally. Yes, stocks had a rough time most recently, and some of the tactical indicators, such as Bull-Bear at -16 which is at the bottom of its trading range, argue for a short-term respite. Clearly, equities are unlikely to keep falling in a straight line, with periodic rebounds likely. However, we believe that one should be using any bounces as selling opportunities.


We fear that the incoming Q4 reporting season won’t be able to provide much reassurance for stocks. As was the case for a while now, consensus expectations have been managed aggressively into the results. The hurdle rate for Q4 S&P500 EPS has fallen from +5%yoy a few months back to -4%yoy currently. If this were to materialise, it would be the weakest quarter for EPS delivery so far in  the upcycle.

Today, the other half of the infamous Croatian duo...


... the legendary "Gandalf" (as dubbed first by Bloomberg) quant Marko Kolanovic, who needs no introduction on this website, and whose every prediction starting in late August turned out just as predicted...

... is out with a new note which will hardly make him any more popular with the permabullish crowd, asks whether "negative  performance in 2015 and January, turmoil in China, and continuing decline in Oil prices make investors wonder if this could be the end of the nearly 7-year bull market."

His short answer:

"The fact that market volatility is on the rise and the Fed is raising interest rates further increases the probability of a Bear Market. The current option-implied probability of a bear market (i.e. ~20% decline this year) is about 25%. While there is no way to predict a bear market, below we look at various scenarios, and estimate that the probability of a bear market may be nearly twice as large."

So according to the man whose every market forecast has been so far impeccable, the probability of a bear market: or a 20% or more drop in the S&P500 - is roughly 50%.

Not good.

And what will make the permabulls even angrier is his proposed allocation to avoid the bear market:

In case an equity bear market materializes this year, investors should benefit from increasing allocation to cash or gold. Cash has zero correlation to all risky assets, while Gold has recently exhibited strong negative correlation to risky assets (e.g. -40% to equities).

* * *

This is what else he says:

from Systematic Strategy Flows, Oil Prices and the Risk of an Equity Bear Market

First, let’s look at relationship between Oil prices and S&P 500. Oil prices recently posted some of the fastest declines on record. Over extended periods of time, Oil and S&P 500 were positively correlated. Figure 4 shows the out/underperformance of Oil relative to the S&P 500 over the past 30 years (trailing 12M relative performance). One can see that that in each of the 10 episodes of large Oil-S&P 500 price divergences, the gap was always closed in a relatively short time period. Significant underperformance of Oil (e.g. >30%) in 8 out of 10 instances resulted in either a decline in the S&P 500 or large Oil rally. In 2 instances, namely shortly after the start of the Gulf Wars in 1991 and 2003, the decline in Oil was a result of overbought conditions immediately prior to these events. One of the largest swings in Oil-S&P 500 performance (comparable to the one over the past year) occurred during the Asia and Russia crisis of 1997/98. The current underperformance of Oil to the S&P 500 is not just one of the largest on the record, but is by far the longest one. Given that divergences of this size closed in 10 out of 10 historical instances, we believe a closing of this gap is very likely.


This can occur either by the S&P 500 falling (e.g. Oil is a predictor of a recession, as in 2008), or by Oil rising (e.g. a reduction of speculative positions, reduction of supply, geopolitical escalation). In any case, we believe that a long Oil and short S&P 500 trade is likely to deliver positive performance in 2016.


A sharp rise in Oil prices could also trigger ‘stagflation’ and lead to an equity bear market. While markets currently estimate the probability of this scenario at less than ~3% (option-implied probability of, for example, Oil doubling and the S&P 500 declining), we think the risk of that scenario is much higher. What could cause a sharp increase in Oil prices? For one, we note that current levels of OPEC production are likely not economically rational or sustainable. For example, to justify an increase in production at a time when prices have declined from $100 to $30, one would need to place triple the production level without further impacting the price.


As geopolitics is likely playing a large role in the Oil price decline, we think it can equally lead to a sharp price reversal. In addition to an agreed production cut, production disruptions are an increasing risk in our view. Recent increases of tension between Saudi Arabia and Iran add to that risk. Parties to a conflict that could independently lead to such disruption include: extremist elements from Saudi Arabia or abroad (e.g. for recent attempt see here), Yemen (for recent attempt see here), Iran, and others. Moreover, high marginal cost producers may drop offline, reducing supply. A doubling of Oil prices may not be a tail event after all (e.g. a significant increase in Oil prices would also be consistent with J.P. Morgan’s current Q4 forecast).


To further assess the likelihood of an equity bear market, we look at historical bull and bear S&P 500 cycles over the past 50 years. We have identified 19 such cycles that alternated in relatively regular periods of time. There were 10 bull markets, lasting on average 4.3 years and delivering ~90% average returns, and 9 bear markets lasting on average 1.1 years and resulting in an average decline of 33%. The current ~205% bull market started in 2009 and is now 6.5 years old. As such, it is one of the longest/largest bull markets. There was only one longer and larger cycle, namely from 1990 to 1998 (that coincidentally ended with the Asia/EM crisis and sharp decline in Oil prices).


The length and return of a bull market is closely related to the size and length of the bear market preceding it (and vice versa). This is shown in the figures below which relate the return during a bear market (horizontal axis) and length of subsequent bull market (Figure 5), and return of the subsequent bull market (Figure 6). In that regard, the current bull market is in-line given the size of the 2008/2009 bear market. In other words, if the bull market was to end now and we are entering a bear market – it would be in-line with historical trends. While this analysis is not proof of an impending bear market, it indicates to us that the chance of entering a bear market this year is probably higher than 25% (currently implied by option markets).



Finally, for the end of a bull market, one needs to have equity prices ahead of their fundamental valuations. While valuation of the overall market is not consistent with a stock market bubble, some pockets do show stretched valuation (e.g. the market capitalization of Internet/Software sectors as % of the S&P 500 is not far from tech bubble peaks).


Figure 7 shows the level of the S&P 500 as well as short-term interest rates (Fed funds). Between 1990 and 2010, the Fed was adjusting short-term rates largely in synch with the price performance of the S&P 500. Historically, the Fed increased rates during market rallies and reduced them during market selloffs, in pursuing its dual mandate of maintaining price stability and maximum employment. This trend broke in 2009. As the US equity market took off, the Fed kept rates at zero and added large monetary stimulus over the next 5 years. This coincided with one of the largest and longest bull markets in US history. During this bull market, stock and bond buybacks increased in pace, with the Fed buying ~15% of government bonds outstanding, and corporates buying back about ~10% of stock outstanding, which were a driver of the increased asset prices. A clear break of the trend between Fed Funds and the S&P 500 might imply that either the S&P 500 rallied too far given the weak growth and appropriate Fed stimulus, or that the Fed underestimated the strength of the economy, in which case the stimulus would have contributed to inflating a bubble. In any case, an increase of short-term rates could be a catalyst for a correction, or even the start of a bear market.


In case an equity bear market materializes this year, investors should benefit from increasing allocation to cash or gold. Cash has zero correlation to all risky assets, while Gold has recently exhibited strong negative correlation to risky assets (e.g. -40% to equities). While bonds have historically been an efficient portfolio hedge, we think that bonds are increasingly at risk of becoming positively correlated to equities (e.g. selling of EM reserves, systematic strategies de-levering, or interest rates increasing).