When it comes to attempts to explain why the market just keeps rising, few case studies are more notable - or comical - than the in-house feud that appears to have developed between JPMorgan's "good cop", head quant, Marko Kolanovic, and JPMorgan's "bad cop" flow strategist, Nikolaos Panigirzoglou.
For the latest example of how two financial professionals can reach diametrically different conclusions, look no further than the latest note published by Kolanovic on Tuesday morning, in which the JPM strategist tries to justify the levitation of the S&P above 3,000 not in the framework of overly dovish global central banks (as that would make his job redundant - after all, just buy everything when central banks are injecting liquidity, and sell when they are draining it), but in terms of investor positioning, as in not enough of it.
Specifically, in explaining which way the market will trade now that it is above 3,000 Kolanovic writes that "over the past month, equity exposure increased" following "record low positioning in equities and other risky assets" earlier in the year when Kolanovic predicted that the S&P would hit 3,000: "In particular, the equity beta of all hedge funds increased to ~60th historical percentile." However, he notes, "equity long-short investors still have relatively low exposure, in their ~30th percentile, despite running high gross exposure."
This is problematic because as we wrote over the weekend, just last Friday, JPMorgan's other quant and fund flow strategist, Panigirtzoglou came to the opposite conclusion, writing that he finds "little support for the idea that there are prevalent equity underweights and “bears everywhere”. Focusing on the key equity long-short investor class, Panigirtzoglou wrote that "Long/Short hedge funds which represents the most important equity hedge fund universe produced a return of 3.2% in June according to HFR and 9.5% in H1, with the two largest L/S sub-categories fundamental growth and fundamental value returning 3.9% and 3.5% in June, respectively. This implies a beta at or higher than 0.5, which is the historical average relative to the MSCI AC World index. Equity Long/Short hedge funds would struggle to produce such returns if they were underweight equities."
Incidentally, the above observation was in the context of Panigirtzoglou's forecast that there is only roughly 8% of S&P upside, suggesting" limited upside for equities from here even if the 1995/1998 insurance-rate-cuts scenario plays out over the coming months" and, worse, "any equity upside would become even more limited if bond markets fail to sustain their H1 gains."
Amusingly, just hours after Panagirtzoglou wrote down those words, JPM completely ignored its in house "bad cop" and as if to rub salt in the wounds of bears and skeptics, upgraded its 12 month price target to 3,200.
And while the recently uberbullish Kolanovic is quick to temper his optimism, noting that "given that the S&P 500 returned over 20% in 6 months, 3,200 in 12 months implies quite a bit lower rate of returns", the quant instead brings attention to what he calls an "unprecedented divergence" between various market segments, which "offers a once in a decade opportunity to position for convergence."
So what is this unmissable opportunity Kolanovic refes to?
As he explains, there has emerged "a record divergence between value/cyclical stocks on one side, and low volatility/ defensive stocks on the other side" with "the level of divergence much more significant even when compared to the dot com bubble valuations of late ’90s." The valuation difference (in forward P/E turns) between value and the broad market, as well as between value stocks and low volatility stocks, is shown below.
One can claim that this divergence is entirely the result of central banks taking over the market, injecting trillions in the global economy and stocks, thereby crushing all value propositions, while the destruction of volatility by central banks whether direct or indirect, has made low vol stocks spectacular winners.
As Kolanovic adds, while there is a secular trend of value becoming cheaper and low volatility stocks becoming more expensive due to secular decline in yields, "the nearly vertical move the last few months is not sustainable", and "the bubble of low volatility stocks vs value stocks is now more significant than any relative valuation bubble the equity market experienced in modern history."
So what could catalyze such a convergence of low volatility/defensives and value/cyclical stocks? According to Kolanovic, several possible triggers are:
- Stabilization of economic numbers (e.g. recent US retail sales, China IP, etc.),
- progress in the trade war,
- the Fed cutting short term rates and related yield curve steepening would help.
That said, given the extreme divergence, the JPM quant thinks that as little as hedge funds increasing net and decreasing gross exposure during the summer rally could trigger this rotation. Hedge Funds’ net is low due to the high level of shorts, most of which come from cyclical and high volatility stocks.
This could, in turn, trigger a chain reaction of short covering, fundamental flows, and equity long-short quant rebalances in a low liquidity environment. This rotation would push significantly higher all the laggards such as small caps, oil and gas, materials, and more broadly stocks with low P/E and P/B ratios.
Whether Kolanovic is right remains to be seen - after all countless traders have bet the house on value outperforming "any minute", only to get carted out feet first. We are, however, delighted regardless, as the "old" Kolanovic, the one who looked for - and found - unique arbitrage opportunities and dislocations in the market, appears to be making a tentative return and whose presence will be far more valuable and greatly appreciated compared to his current stock bubble-chasing 'at all costs' successor.