"How close are we to the market top?"
While that is and always has been the question on every trader and investor's lips, it is also what an increasingly greater number of more and more nervous JPMorgan clients wants to know, especially those who, according to JPM head quant Marko Kolanovic - want to protect strong YTD gains or chase year end performance. What sucks is being designated the person responsible with answering this question. In this case, that's person is the quant guru himself, who explains that "to assess this question we analyze equity positioning, possible signs of irrational exuberance, and again draw attention to another form of excess which we call ‘quantitative exuberance’.
Here are Kolanovic's three answers to how much higher stocks could go before hitting the bubble ceiling.
While we think that the Tax bill will be a positive catalyst that would move equities higher, there is only so much the market can rally if equity investors are already near maximal allocations. These allocations are near historical highs, not leaving much room for further increases. Numbers are shown as historical ‘percentiles’. Starting with retail investors one can notice that margin debt (measured as percentage of market capitalization) is at its highest point ever, which includes the 2000 tech bubble episode. The percentage of US household wealth in equities is in its 94th percentile and above its 2007 peak, but slightly below 2000 levels. Sovereign wealth funds and US mutual funds are also near record levels. Pension Fund allocations appear to be in the 88% percentile, although there is some uncertainty around this number in adjusting for private asset and HF holdings. Global Hedge Funds’ allocation (as measured by equity beta) are also near record highs, and Equity Hedge funds’ allocation in their 93rd percentile (since 2005).
Previous market tops often coincided with the phenomenon of ‘irrational exuberance’. While we argue below that this is not needed for the market to top, we look at the signs of excesses in the marketplace. One such measure is increased interest of retail investors in equities. We note a significant spike in the pace at which retail investors open online equity accounts, comparable to 2000 levels. However this level of interest only started this year, while it persisted for over 2 years going into the tech bubble burst. We also note that retail interest in speculating this time is shared between traditional assets and cryptocurrencies (as indicated by an analysis of online searches for account opening). We see this as another sign of excess and risk as the cryptocurrency market passes 1% of US GDP (not counting stocks traded for proxy exposure). The excesses in equity markets are likely related to the internet/tech, a theme shared with cryptocurrencies. For instance, we think that many tech companies deemed to be part of the ‘secular growth’ thesis are in fact part of ‘cyclical growth’ and are exposed to large downside risks in advertising revenues during the next downturn. In fact some may also be exposed to ‘secular declines’ (rather than growth) as over time products lose appeal to new generations. It is possible that post-millennial generations abandon current online environments and platforms, deeming them mentally or physically unhealthy, overly intrusive of privacy, or controlled by special interest (e.g. issue of censorship, etc.). Valuation is another topic we discussed at length in our previous work, and new anecdotes of excesses appear every day (e.g. institutional funds investing in make believe apparel for virtual online gaming characters).
We also think that for the next market crisis, irrational exuberance in the ‘tech bubble’ sense is not needed. The reason is the prevalence of quantitative and passive strategies that don’t decide based on emotions, but rather based on measures such as the level of interest rates, volatility, price momentum, or bond-equity correlation. Examples of these strategies include Volatility Targeting, Low Volatility strategies, Trend Following strategies, Risk Parity strategies, Dynamical hedging strategies, Volatility selling strategies, and others. In addition, there are relative value strategies that transmit risk premia compression across asset classes and strategies. With volatility at record lows and central bank balance sheet inflows peaking this year, these strategies currently experience ‘quantitative exuberance’ that poses risk when monetary policies start normalizing in a meaningful way next year.
Hmmm, a "risk when monetary policies start normalizing in a meaningful way next year" - sounds oddly similar to Michal Hartnett's warning that in the first half of 2018 the world will observe not only the bond bubble bursting, but also a 1987-like flash crash. But don't worry, as both Macquarie's Viktor Shvets and One River's Eric Peters explained over the weekend, the financial Armageddon that is coming... is bullish. Here's Shvets:
We remain constructive on financial assets (as we have been for quite some time), not because we believe in a sustainable and private sector-led recovery but rather because we do not believe in one, and thus we do not see any viable alternatives to an ongoing financialization, which needs to be facilitated through excess liquidity, and avoiding proper price and risk discovery, and thus avoiding asset price volatilities.
... and Peters:
The extraordinary response to the global financial crisis prevented depression. But the price of salvation is proving to be as profound as it is impossible to precisely measure -- unexpected election outcomes, political paralysis, an isolationist America, de-globalization, fake news, opioid epidemics. And connecting it all, a corrosive, woven thread; injustice, unfairness, inequality, hypocrisy, distrust, endemic, growing. “We are on the cusp of great change, the old paradigm is set to shift,” he said, at altitude, the air crisp, clear.
“The market has an accident, monetary policy is seen to be bust, the models have been wrong, we have to change what we do, we can’t go down the same route, we need to move to a different policy mix. Fiscal expansion, infrastructure, labor over capital. We’re moving to something that may be great for the economy, but no good for asset markets. New Regime -- end of story.