The last time JPM’s head quant Marko Kolanovic warned about imminent market volatility was just two weeks ago, and was duly noted here in “JPM’s Head Quant Is Back With A Stark Warning: Volatility Is About To Surge; Here’s Why.” And, as has so often been the case, he was right: as he follows up in a victory lap note released moments ago, Kolanovic notes that “in our note on September 6th, we called for an increase in market volatility and deleverage of systematic strategies. A few days after, the volatility of US equities tripled and global equity markets were down between 2.5% and 5%. The pullback in US markets was smaller than overseas as S&P 500 price momentum held positive (CTAs didn’t go short the S&P 500) which we forecasted would be a stabilizing factor (in addition, there was a large idiosyncratic move up in Apple and related companies).”
That said, the selling was less than he expected: as Kolanovic notes, since “S&P 500 momentum held and short term volatility stayed below 20% (in part due to VIX investors rushing to sell around half of their long ETP exposure), the amount of equities sold was likely half of what was sold in August/September of last year.“
Another stabilizing factor was the low exposure of long-short equity hedge funds that did not have to sell (unlike last year). Another interesting development is that the liquidity of equity markets held up very well during the selloff. Equity market liquidity (as measured by futures market depth) was fairly high during July and August, and when deleveraging started on September 9th, liquidity dropped more gradually. The Figure below shows the relationship between market volume and market depth/liquidity for S&P 500 futures over the past year. One can see that during the most recent surge in volume (and selling) market depth was ~3 times higher than on 8/24/15.”
Which brings us to the latest systematic, quant, risk-parity and CTA positioning update, and unlike on previous occasions, this time Kolanovic believes that there is no longer anything to write home about, seeing smooth sailing ahead:
According to our estimates, selling from systematic strategies is now mostly completed. This is assuming that S&P 500 momentum stays positive (most likely, in our view), and that volatility does not significantly increase further (as important central banks meetings are out of the way). As the market bounced post Fed and September options expired, the large put option (gamma) imbalance subsided and is no longer pushing volatility higher (e.g. as was the case on September 9th). Given the publicity and research on systematic strategies, it is also possible that managers are adapting to new market conditions (systematic managers putting more emphasis on liquidity, and fundamental investors/asset managers use systematic de-leveraging as an opportunity to increase exposure or sell volatility).
Are there any catalysts on the horizon that Kolanovic is concerned about: the answer, at least until the presidential election, is no: “BOJ and Fed outcomes were dovish. Between central banks and reduced leverage in systematic strategies, major risks for the markets are removed near term. The next major catalysts are US Elections and central bank meetings such as December Fed (which we will address below).”
Notably, having previously warned about potential selling overhang, this time Kolanovic urges JPM clients to go into some of the most risk-on assets they can find, although notes that “upside for the whole S&P500 is likely not large given already high valuation”… although when is the last time record PE multiples stopped algos from buying:
Short term, we favor a continuation of Value, Carry, and Reflation ‘risk-on’ trades that include long EM stocks, Commodities, and DM stocks that have cheap valuations (we advocated those since December last year, see here). Short term upside for the whole S&P 500 index is likely not large, given already high valuations (e.g. yield sensitive and low volatility stocks) and uptick in market volatility.
What is curious is that unlike others, Kolanovic is not even concerned about the outcome of the presidential election, saying that a Trump win is not a risk for equity markets:
As we indicated in our previous reports, and counter to various surveys, the outcome of US elections appears to be largely a coin-toss. This is increasingly supported by national polls and electoral vote probability distributions, most of which are within the margin of error. While the prospect of Trump winning the election may be unnerving for some investors (especially those overseas), we do not think that Trump’s potential win is a risk for equity markets. In fact, certain structural effects may even result in short-term upward pressure on equities. There is a close analogy between Brexit and the US elections, in our view. In the Brexit case, the establishment underestimated the probability of losing the referendum, but overestimated its short term negative consequences. We do not think the US election should be an impediment for investors in risky asset such as value stocks, commodities or emerging markets.
So is there anything that can prevent new all time highes in the near-future? The answer: only central banks.
We believe the major risk for investors continues to be potential tightening from central banks, high valuations in certain segments of equity markets, and the ‘ageing’ US business cycle.
And since Yellen yesterday responded that she is not worried about creating asset bubbles, it appears that – at least when it comes to market technicals – one major brick from the wall of worry has been removed.
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