One week ago, amid a duel of forecasts between Morgan Stanley "rolling bear markets" thesis, JPMorgan's head quant Marko Kolanovic tripled down on his bullish outlook, when he cautioned that "many investors are positioned for a ‘rolling bear market’ and are exposed to the risk of a ‘rolling short squeeze’ into year-end."
He also predicted that after the US market sell-off and slowdown in China, "progress on the trade war is more, rather than less, likely." And echoing the sentiment presented by Nomura's Charlie McElligott, who earlier today anticipated today's market melt up as levered funds chase indices into year end, Kolanovic said that with global Hedge Funds down ~4.5% and the market up ~2% YTD, missing the past week’s ~5% rally would have made a big difference, especially as their shorts moved more than longs.
In retrospect, and 6% higher from the October 30 lows, Kolanovic was right, and after solid gains over the past several days, the JPM strategist says that "the question is what should investors do next?"
Perhaps not surprisingly, Kolanovic remains bullish and thinks that the market will move higher into the year-end, as "investors may have to participate on the upside (appropriate exposures may be high-beta indices such as Russell 2000 and MSCI Emerging Markets)" especially in the context of McElligott's source of "short gamma" which is pushing the market ever higher the more stocks rise. Furthermore, Kolanovic notes several factors that improved since last week "that keep our upside view intact." He lists the following:
- November is shaping up to be the strongest buyback month on record (based MTD activity observed by the JPM desk).
- Short convexity of market makers is rapidly declining and may turn long. This should be positive as it will bring back intraday reversion as opposed to momentum. This reduces realized volatility, and many investors will misconstrue this as a return of the ‘buy the dip’ environment.
- Realized volatility is expected to decline. Systematic investors (such as vol targeters) will start rebuilding positions into year-end. This may not be a main driver, but could add ~$1bn of inflows per trading day into year-end.
- Implied volatility has declined, with the VIX term structure reverting to contango. For some strategies this is a positive signal.
- Next week, 1M price momentum will turn positive for most equity indices globally (1M ‘anniversary’ of the crash), and may lead to CTA inflows or short covering.
- Elections have passed, and it removed the tail risks of a blue wave (impeachment, repeal of tax reform, etc.). This should be positive for sentiment.
- Split congresses have historically been positive for the market, and this time it reduces the probability of the most negative trade war outcomes.
- The US earnings season turned out to be one of the strongest in a decade: 98th percentile on bottom line, 97th percentile on top line, above average on guidance/revisions
Kolanovic then rounds out his note with some observations on the US midterm elections, stating his "out of consensus" belief that a split Congress "is the best outcome for US and global equity markets." Specifically, policies of the US administration in 2017 were strongly pro-business (we pointed that out in 2016). However, in 2018, policies of the US administration were strongly anti-business.
Kolanovic also counters conventional thinking by saying that if we had a “red wave,” the administration might have seen it as an endorsement of the trade war, and attempt to mitigate the breakdown in global trade with more US fiscal expansion (e.g., 10% middle-income tax break, etc.).
As the President cannot count on Congress or the Fed for more easing, he will need to do what is in his power to keep the economy rolling – drop the damaging trade war and turn it into a winning deal.
Finally, the JPM strategist coments on the October sell-off whichhe dubs as "one of the more curious events in US financial history." This is how he frames last month's freak market rout:
In 2015, we were saying that systematic investing and electronic liquidity provision can yield any price outcome regardless of fundamentals. The worst 1-month sell-off since Lehman this October reminded us of this again.
While the fuel for the sell-off was systematic flows, low liquidity and HF deleveraging, the catalyst was politics. It was essentially a miscalculation and a conflict between the US Administration and Fed going into important midterm elections. Shortly before the sell-off, we wrote about Equity markets being very uneasy with the increasingly hawkish rhetoric from the Fed. At the same time, we pointed out that Trump may be miscalculating on trade and the US market was not pricing the negative EPS impact of a trade war. The reasons for the Fed ramping up hawkish rhetoric going into one of the most important midterm elections in US history will continue to be questioned by market practitioners. There was a global trade war scheduled to start, signs of stress from US housing to emerging markets, an ongoing crisis in the Eurozone (Italy), and finally the worst 1-month sell-off since Lehman (recall that historically rhetoric eased/turned dovish for much smaller reasons such as the last French elections).
Going into the election, the US administration perhaps miscalculated that the NAFTA deal would be enough to prop up market sentiment, and that the Fed would provide dovish ‘cover’ for the trade war. In the context of rallying the Republican base on immigration and trade (rather than winning independents and moderates), trade rhetoric escalated going into election (e.g., the ‘Super Micro’ affair). A dovish Fed would have propped up markets and underwritten the trade war policy going into election, but the hawkish Fed ended up triggering the market crash.
His conclusion is that the "catalysts for the October crash were miscalculations on both sides, and we hope lessons will be learned." Whether he is right will largely depend on Trump's actions going forward: whether he takes a conciliatory stance having lost the House, or if - as some such as Goldman have suggested - Trump will double down on his trade war rhetoric and efforts, and pushes even harder on his core policies which would lead to another round of market instability.