With the market now well below both the September all time high, and the January "blow off top" spike, and unable to make new highs despite a third consecutive earnings season which will see earnings rise by a whopping 22% Y/Y, shrinking fwd PE multiples further and invite value investors to rotate out of growth stocks, traders and analysts have been quietly asking if "something changed" whether in terms of market sentiment and composition.
According to a new note released by Goldman's derivatives strategist John Marshall, the answer is yes.
In the note, Goldman claims that the October sell-off has "reinforced our view that professional investors and US corporates are in the midst of a deleveraging process."
We believe this shift began with the February 2018 VIX spike which kicked off a risk reduction among professional investors that will affect borrowing costs and corporate leverage.
As part of its gloomy assessment of the future, Goldman looks at the history books and notes that it sees parallels with the 2007 Quant Meltdown, which "was the initial deleveraging event that marked “high tide” for the discretionary use of leverage by professional investors and corporates in the 2008 cycle."
Commenting further on the unexpected shock to markets that hit in August 2007, and comparing it to the Feb Vix spike, Goldman notes that "both coincided with a 10% drawdown in the SPX. Both were in a corner of the market that professional investors know well, but may be less well-known to retail investors. Both occurred late in the business cycle when credit spreads and volatility were at historic lows." Marshall continues:
The Quant Meltdown of 2007 did not directly cause the mortgage crisis, but was the turning point for professional investor sentiment. Likewise, we don’t think the VIX spike directly causes the next crisis, but it heightens the importance of monitoring professional investor positioning. The Quant Meltdown changed the willingness of investors to increase leverage in their portfolios; either due to a change in investor sentiment or an explicit widening in borrowing costs. At first, professional investors stopped adding to Investment strategies which relied too much on leverage. Following a long period of increasing leverage, simply “not adding leverage” can be enough to change sentiment about future leverage levels.
So if recent Vol events are indeed a parallel of the 2007 quant meltdown which presaged both the peak in the market and the onset of the December 2007 recession by just a few months, what is Goldman focusing on now, and why is it specifically targeting professional investor positioning? To answer that question, Goldman discusses the 7 metrics that it uses to track the “tide going out” and track its transmission to corporate fundamentals, with many of the metrics "showing this deleveraging trend clearly." We list Goldman's considerations below
First, Goldman focuses on professional investor positioning - which it believes "is a better proxy than retail investor positioning for investor sentiment as it relates to future risk and returns." Of note, the bank notes that retail investment flows, which have increasingly been skewed toward passive vehicles, are more related to the availability of capital to invest and competing needs for that capital (desire to spend, inflation, debt service) rather than an explicit view of forward return expectations in markets. To paraphrase the above in far simpler terms: professional investors are selling and retail investors are buying what they have to sell, which traditionally has never been a good sign.
1. Since January, “Professional ETFs” have seen outflows while “Retail ETFs” have seen steady inflows.
ETFs are used by both retail and professional investors. We estimate professional investors are holders of 50% of the listed ETF options market, despite only holding 6% of the ETF shares market. The exposure represented in the ETF options market (particularly if one includes over-the-counter derivatives and swaps) exceeds the underlying shares market, but is focused in a subset of ETFs. Whether for liquidity reasons (SPY, QQQ) or for exposure reasons (XOP, XRT, IYR) professional investors tend to use some ETFs more than others. Goldman categorizes the largest 74 ETFs as “professional” or “retail” based on ownership data, options volumes and our own experience in working with institutional investors. The professional investor outflows have been more pronounced and steady when considering equity ETFs, but have also occurred in fixed income ETFs.
2. Futures show a reduction in net exposure for equity and bond investors over the past 7 months; however, institutional investors seemed to re-risk in equities during September.
Net Length in SPX futures (as reported by the CFTC) went from a multi-year high to a 1-year low from January to September. Similarly, positioning in the Treasury futures market shows a significant increase in investor short positions. Trading volumes in these futures markets are large, making them a relevant proxy for changes in positioning. SPX futures trade 1.3 times as much as cash SPX on an average day while the Treasury Futures market daily volume is about the same size as volumes in cash Treasuries. We continue to monitor positioning in these markets which are exclusively used by institutional investors/asset managers. We will be closely watching SPX futures positioning in particular given the reduction in net length has resumed in the past two weeks.
Next, Goldman looks at the specific transmission mechanisms that define key market inflection points such as borrowing costs, equity and overall market vol. Specifically, as professional investors have pulled back on positions in equity and bonds, the cost of borrowing, expectations for volatility and concerns about market liquidity have increased. In the next few points, Goldman shows how these factors have evolved, while also monitoring how these factors affect corporate borrowing decisions, financial conditions and the economy.
3. Borrowing costs are increasing quickly as rising rates exacerbate the impact of widening credit spreads.
In this section, Goldman compares the significant reaction of credit spreads in 2007 (light blue left chart) to the more moderate reaction in 2018 (light blue right chart). This suggests professional investors pulled back on risk taking in credit more dramatically in 2007 and we are seeing a much smaller widening in 2018. The dark blue lines in the charts below show total borrowing costs for Investment Grade companies including 5 year rates plus credit spreads. In 2007, interest rates fell more quickly than credit spreads increased, so there was a negative net impact on borrowing costs. This reduction in borrowing costs provided a buffer that limited the fundamental feedback loop to corporate borrowers. In 2018, the increase in rates has EXACERBATED the rise in borrowing costs, thus exacerbating the transmission of institutional investor positioning to US corporate borrowers. Based on 5Y rates plus credit spreads, the absolute cost of 5-year debt for IG companies stands at 4.2% currently relative to 5.0% eight months after the quant meltdown of Summer-2007.
4. Equity volatility: increase in 2018 has been smaller than in 2007, but started from a higher level.
SPX 1-year volatility expectations have increased from a low of 15 to 20 over the past 8 months. Even following a volatile couple of weeks, this increase of 5 volatility points is much smaller than the increase in a similar period in 2007 when 1 year volatility expectations increased from 13 to 26. This suggests that risk aversion among equity investors has had less than half the impact of the 2007 cycle. To monitor long-term risk-aversion, Goldman is watching long-dated volatility rather than VIX or short-dated volatility which is often impacted by upcoming events or short-term volatility expectations.
5. Market Makers providing less electronic liquidity in SPX Futures markets.
As discussed previously, Goldman has been monitoring the “top-of-book depth” of the SPX futures market as a proxy for how much liquidity market makers are willing to provide throughout the day. As one might expect, market depth declined rapidly in February, around the time that volatility spiked; however, market depth has failed to return as quickly as volatility has declined. This implies that for a given level of volatility, market makers are providing less liquidity. Lack of market liquidity has the potential to exacerbate market moves for a given change in fundamentals. In the sell-off last week, top-of-book depth dropped quickly and its recovery has been slow even on days when the SPX was up. In past cycles, fundamental investors monitored leverage as a key warning signal for corrections.
Having discussed specific positioning and market technicals, Goldman then proceeds to discuss the economic impact on corporate leverage and growth, specifically noting that a rise in the cost of capital in both equity and bonds combined with other dynamics including tax reform and global risk aversion, have led corporates to reduce net leverage. This is notable because this reduction in leverage, while risk-reducing for any individual company, has the potential to translate into lower future earnings and cash flow growth for even companies that are not reducing leverage. Lower growth leads to less investment, reinforcing the fundamental feedback loop.
6. Corporate leverage is in decline: Decrease in Debt Issuance, increase in Cash Balances are only partially offset by Buybacks.
Marshall writes that Goldman monitors leverage ratios for evidence that corporates are pulling back on investments and risk. Investment Grade companies have issued far less debt this year than normal, partly due to the increased domestic cash balances following tax reform but also due to strong operating cash flow. Low net issuance in credit markets (low supply) has created a scarcity of securities at a period where the search for yield remains robust (high demand), allowing the bond market to perform well; however, this lack of issuance means there is less capital deployed in the economy for capex or inventories. As borrowing costs rise, the incentives to limit new debt issuance will climb, further increasing the hurdle rate for new projects. In 2007, the Fed reacted quickly by lowering interest rates as soon as credit spreads widened (Exhibit 4 above). In 2018, the rise in rates is exacerbating the more modest credit spread increase. Goldman sees early signs that the increase in rates is causing lower debt issuance at the margin; as a result the bank's analysts expect leverage to fall (light blue bars, bottom-up based estimates), extending the deleveraging trend that began in 2017.
7. Economic impact of equity declines.
As we showed over the weekend, according to Goldman economists, the 6% decline in the stock market since late September has been the most important driver of the recent tightening in financial conditions. They estimate that the 0.5pp boost to GDP growth from higher equity prices at the start of the year has already disappeared. Following the recent sell-off, their base case is that the equity impulse to growth declines further to -0.25pp next year; this would account for half of the -1.5pp swing in the FCI impulse from a boost to a drag since the start of the year, but the uncertainty is substantial, in part reflecting two-sided risks to equities themselves. An exogenous additional 10% decline in stock prices would increase the drag to 0.75pp annualized and could be enough to push GDP growth below potential next year, given the simultaneous waning of the fiscal impulse. Conversely, a stock market rally at a 4% pace per quarter would likely lead to a rebound in the equities impulse to +0.25pp and keep GDP growth well above potential.
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While virtually every bank in recent weeks has laid out the growing risk to the bullish cash, none - with the possible exception of Morgan Stanley - has been willing to go so far as to stake a specific bearish call, and this Goldman note is no different because as Marshall concludes, "we do not view the above metrics as suggesting there is an impending bear market or recession."
However, the bank does believe there is rising potential for a market drawdown, increased volatility and asymmetries in equity return distributions. Marshall's advice? buy options to mitigate risk:
Traditional portfolio hedges are attractive, particularly those with terms of longer than 1 year. Call buying in single stocks is an attractive substitute for long-stock positions to maintain upside exposure while limiting risk in a drawdown.
On the other hand, if Goldman is correct and the recent market volatility is presaging a market quake, similar to what happened just one year after the August 2007 quant meltdown, it is unlikely that option-based hedges - which are reliant on the survival of one or more financial counterparties - will do much at a time when the Fed's only recourse will be to shut down the market for a brief, or not so brief, period of time to preserve and restore confidence.