Yesterday's sharp S&P selloff, the largest of 2017, and the first time the market dropped by more than 1% in 110 trading days, may be just the beginning: that is the troubling thesis presented by JPM's quant Marko Kolanovic, who as we quoted yesterday, warned that "following Friday's option expiry, the gamma imbalance shifted towards puts for the first time in ~5 months and the market was ‘free’ to move again. Hence, it should not be a surprise that today, for the first time in ~5 months, we have a meaningful down move and intraday acceleration."
He concluded with another warning:"We maintain that the market is entering a vulnerable phase, where increased volatility can further contribute to equity outflows" and added that contrary to the narrative, yesterday's selloff was "primarily technical and should not be fitted into a political narrative.'
While there is no uniform agreement over the causes of yesterday's selling, RBC's Charlie McElliggott seems to agree with JPM that the selling which accelerated in the last half hour of trading is more "technical driven" than political/emotional, although as he explains it could potentially turn into an "emotional" selloff. Having warned about the "complete breakdown" in the quant model yesterday, a further deleveraging - i.e., selling - is dependent on whether the 'mechanical' to 'emotional' transition takes place today:
"...yesterday’s ‘vol-trigger’ induced mechanical risk deleveraging, which largely emanated from the accelerating breakdown in USD (and thus ‘reflation’) exposures...The final 30 minutes of the EU and US equity sessions will be a key-indicator in determining if there is ‘follow-through’ in the deleveraging. This is where ‘mechanical’ can transition to ‘emotional’ for fundamental players."
Here are his summary comments on the selling and what to look forward to:
- Yesterday was a mechanical deleveraging ‘VaR move’ as indicated by the Dollar’s breakdown as proxy for broad ‘reflation’ positioning.
- ‘Reflation’ trades had already seen waning momentum with the current fiscal policy implementation scare.
- To see a larger ‘deleveraging drawdown’ would require sustained higher volatility to ‘drag up’ realized vols in 20d / 60d models for short-term models—more than just a few days ‘blip’ in VIX.
- The final 30 minutes of the EU and US equity sessions will be a key-indicator in determining if there is ‘follow-through’ in the deleveraging. This is where ‘mechanical’ can transition to ‘emotional’ for fundamental players.
- VaR encourages leveraging / deleveraging at ‘wrong times,’ i.e. ‘easy carry’ built-into system during a low-volatility regime.
- Shorting volatility is a multi-year alpha generating strategy utilized by the largest pension funds, asset allocators, asset managers and hedge funds alike that has profited from selling into short-term vol spikes (similar to ‘buying the dip’). It will be continue being done until it ceases working; it remains a +++ performance driver for now.
- These ‘sharp’ drawdown events will continue to occur with greater frequency. It’s a product of having more AUM than ever in systematic-trend / tactical-allocation / model-driven rebalancers nearly all with “vol targets” setting their leverage or allocation and thus, ‘momentum’ inherent at their root.
- Price-action and anecdotal client feedback shows nets taken down, grosses taken higher as shorts are pressed.
And from RBC's detailed commentary:
Global cross-asset markets this morning show a ‘very modest’ follow-through (Spooz flattish, $/Y -40 pips, WTI -1.4%) on yesterday’s ‘vol-trigger’ induced mechanical risk deleveraging, which largely emanated from the accelerating breakdown in USD (and thus ‘reflation’) exposures.
Thus far today though, the Dollar has stopped the bleeding, most notably against Euro, Mex Peso, Cad Dollar, Kor Won, Aus Dollar and Pound:
Rates / duration-shorts have been squeezed as expected, which is representative within equities of classic ‘risk-off’ / low-vol defensive behavior--“Anti-Beta” market neutral strategy saw its best one-day return since July 5th of last year, and 6th best day in the past two years. Not surprisingly with the move lower in nominals and breakevens, we saw real yields move lower as well, with 5Y TIPS yields back to -16bps this morning from +4bps on March 14th.
Back to yesterday’s trade: Let’s be honest—it was just a -1.2% move in SPX. But it was ‘ugly’ under the surface, with many of the below moves indicative of VaR ‘taps’:
- Dollar TWIs saw their second day in five of a ~2 standard deviation move lower (most notably against major squeezes in crowded shorts Euro, Pound and Yen);
- Credit saw High Yield and Bank Loan ETFs each see 2 standard deviation moves lower;
- Equity HF VIP Longs -1.6%;
- Copper -1.8%;
- WTI -1.8%;
- Equity ‘Value’ factor longs -1.8%;
- Basic Materials -2.0%;
- Equity ‘Beta Cyclicals’ -2.4%;
- Small Cap (R2K) -2.7%;
- ‘Early Cycle’ equities -2.8%;
- ‘High Beta’ equities -3.3%;
- US banks -4.8%;
- Beta biotech -4.9%
As I stated in yesterday’s note, the ‘long Dollar’ trade is the core of ‘reflation’-linked crowded macro trades. To see it ‘crack’ was the key to the larger short-term model systematic VaR deleveraging which then rippled across said consensual ‘reflation’ positioning, which had already shown weakening momentum as actual fiscal policy implementation dynamics are ‘real-time’ sapping sentiment (see healthcare vote tomorrow and implications on tax-cuts).
But to know if this move is something more meaningful than a one-day dynamic, I think you have to look to the final 30 minutes of the EU and US equities closes today. It is entirely possible that the sessions behave “normally” per recent standards, grinding higher over the course of the day even. But those final 30 minutes are so critical as indicators, because that is where we would be seeing the concentration of “mechanical” funds further deleveraging as a sign of “follow-through.”
But as far as the %age of money being run on models “short-term enough” where just one +10% day in VIX is going to completely shift the allocation is--finger in the air--not enough to perpetuate the unwind. Recall yesterday I highlight 60d SPX historical vol having printed 10-year lows through March 20th at 6.4? For relativity, after yesterday’s “vol spike,” that 60d realized vol is now just 7.1. That's why I keep stressing that higher vols need sustain for days to drag up 1m and 3m realizeds “high enough” to trigger ONGOING rebalancing / deleveraging.
VaR as a risk-management tool is unfortunately ‘pro-cyclical,’ meaning that backwards-looking realized vol models inherently encourage ‘leveraging up’ / deleveraging at the perfectly wrong times (meaning it understates risk in ‘low vol’ regime and overstates risk in a ‘high vol’ environment). And in the case of this current ‘vol-supressed’ regime, where asset allocators and pensions and assest managers and hedge funds alike are all encouraged by the alpha-generating returns of shorting vol into Central Bank asset purchases and NIRP / ZIRP, you can really ‘load the coiled spring’ with easy carry until something ‘tips over.’
Awkwardly, the industry-wide thirst for alpha (now more than ever in light of the performance dynamics of prior years, with now half of hedge funds back below their high-water marks—i.e. half the universe isn’t getting paid on performance again) has conditioned PM ‘muscle memory’ to further load the coil and sell vol / buy the dip. Until we see a failure in either of those strategies, expect this ‘stat quo’ to continue.
The point that I have to keep reiterating here though is that in light of the today’s market structure and where the assets, these events will continue to occur with greater frequency. It’s a product of having more AUM than ever in risk-parity / systematic-trend / tactical-allocation / model-driven rebalancers ALL with “vol targets” setting their leverage or allocation and thus, ‘momentum’ inherent at their root. It’s unemotional and as always, doesn’t require a ‘headline’…sometimes it’s just a ‘butterfly flapping its wings.’
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One final point with regards to the ‘surveying’ of funds on exposure moves into and off the back of yesterday, it was clear that the majority of yesterday’s portfolio movement was selling of longs. Many shorts were actually pressed, so I would expect to see more of this today: GROSSES TAKEN UP and NETS TAKEN DOWN.
NETS DOWN, GROSSES UP AS LONGS SOLD, SHORTS PRESSED:
MOMENTUM LONGS (INFLATION, CYCLICALS) SEE THEIR SIXTH WORST DAY IN TWO YEARS:
MOMENTUM LONGS = INFLATION / CYCLICALS: