Early in the October dump, JPMorgan's head quant Marko Kolanovic predicted that the recent selling pressure, which he said was due to option gamma hedging, was ending and noted that since "equity indices already experienced comparable declines to February (and e.g. Russell 2000 even a bigger drawdown), we think that the current setup favors buying the dip."
It did not, because after a brief bounce, stocks then tumbled some more.
One week later, Kolanovic doubled down on his bullish take, focusing on option hedging which he said "is a temporary impact (intraday momentum) that tends to revert" and went on to justify this week's volatile, erratic market action largely in terms of continued option hedging which he also saw as ending.
Stocks stabilized briefly... then the selloff turned even more violent (with Monday's late day mega sell program having all the fingerprints of a systematic liquidation, which allegedly was "over") with the S&P briefly entering a correction on Monday, while hedge fund favorites, the FANG stocks, entered a bear market.
In fact, it got so bad that as Nomura noted earlier this morning, the market selloff has basically trapped hedge funds, who are damned if they delever and damned if they try to pick a position in the market in hopes of BTFD and timing the bottom:
equity hedge fund performance continues to suffer due to legacy positioning effectively being "long high beta" vs "short low beta", which means that despite cutting net exposure to lows, they still bleed on high "market" exposure:
As for Kolanovic, having been burned on his market timing calls twice in a row in the span of three weeks, did the JPM quant finally throw in the towel? Apparently not, because as his latest piece shows, he is now tripling down on his bullish call, and while no longer calling for the end of systematic selling to be a bullish catalyst, he has instead shifted his sight to hedge funds who have gotten crushed (perhaps after listening to those making repeat bullish calls in the past few weeks) and is betting that in their year-end performance scramble, hedge funds will have no choice but to load up on high beta garbage forcing a market squeeze in the process.
First, just like Nomura's cross-asset quant McElligott, Kolanovic lays out the all-out bloodbath in the hedge fund space as follows:
October was a brutal month for equity fundamental and quantitative investors. The past week was particularly damaging, where technical selling from the first part of the month (~$150bn) abated, only to be replaced by hedge fund de-risking and a rout in Tech stocks. The global HF equity beta dropped from ~95th percentile in September to ~15th percentile now (over the past 5 years), one of the largest and fastest declines on record. Our prime brokerage team noted that HF net exposure dropped from near all-time highs in September, to 2015 lows (lower than in February this year).
Kolanovic also notes that hedge fund HF shorting (as % of gross) in JPM's prime book also increased to the highest level since 2015, and for good reason: as the chart below shows, shorts are finally making a killing, enjoying the best return since January 2016, when China almost crashed the world before the Shanghai Accord resulted in a global, coordinated central bank intervention.
Meanwhile, Kolanovic also notes that given equities recorded their worst 1-month return in over 9 years, "asset managers who rebalance to fixed weights on a monthly schedule are currently the most underweight equities since February 2009." He also repeats what he said two weeks ago, namely that "systematic investors are also near the bottom of their exposure – volatility targeting strategies’ equity holdings are similar to February lows, and many CTAs are outright short or out of equities."
In short, "A ~10% decline from the peak and markets turning negative for the year triggered all kind of institutional stops, driving the sell-off deeper."
Here Kolanovic, who incidentally did not anticipate any of this, is confused: "Did the macro and fundamental outlook deteriorate enough to justify this extreme swing in investor positioning" he asks and answers bullishly:
In October, US GDP surprised expectations to the upside, core PCE remained steady, and ~80% of US companies reporting Q3 earnings beat analyst expectations that were formed before the sell-off, while forward guidance remains largely unchanged. Given the weakening economy in China and poor market performance in the US, there may be an increased (rather than decreased) probability of November progress on trade.
Which brings us to his, relatively naive, bullish thesis: a squeeze higher, the same thesis that Charlie McElligott was pitching back in August, and admitted earlier this week that it was not going to work. Well, here's Kolanovic to double, pardon triple down, on his bullish thesis:
With investors positioned defensively, and leverage rapidly coming out of system, there is an elevated risk of market reversion into year-end. Investors should keep this risk in mind – namely that an October ‘rolling bear market’ turns into a ‘rolling squeeze higher’ into year-end. This would cause further underperformance of active managers relative to broad indices.
Why yes, which is why as Nomura said earlier, hedge funds are damned if they buy, damned if they do nothing.
As for Kolanovic, who with this 3rd consecutive bullish call in a row is now staking his reputation on a rebound in stocks, gives the following justification for what could drive this potential rolling squeeze higher:
First, we note that October month-end will lead fixed weight asset managers to increase their equity exposure. Given the size of the move in October (largest since Feb 2009), that could contribute to ~1-2% of upside market pressure (based on the historical beta of month-end reversion).
Buyback activity is expected to increase significantly going forward (~$200bn realization run rate to year-end).
We also expect volatility to decline into year-end, which should prompt systematic investors to re-build equity positions (~$100Bn).
Finally, any progress on trade could result in discretionary inflows, reduction of current elevated short positioning, and year-end performance chase.
All of these are valid arguments. They are also completely meaningless if, as Morgan Stanley observed - correctly - the "Buy The Dip" strategy - for a decade the savior of countless copycat funds - is now dead.
As for the downside case to Kolanovic' thesis, that selling and liquidations will beget more selling and liquidations, well we expect to hear about that in his next note in 1-2 weeks when he will quadruple down on a bullish bounce...