With all the risks in the world, why is the stock market moving higher? JPMorgan’s Quantitative and Derivatives Strategy head Marko Kolanovic has the answers to this question, as well as a take on where volatility is headed and how CTA strategies are positioned. When looking at the Brexit “V” stock market crash and resulting recovery, in an August 2 report he pegged a controversial causation for the move: unreported central bank market intervention.
Kolanovic: Combination of monetary & fiscal policy driving stocks higher
When considering the geopolitical uncertainty that impacts stocks, Kolanovic first points to consensus causation that includes Brexit and potential for Donald Trump to win the US Presidency. But he also factors the increasing frequency of ISIS attacks and release of 28 pages of the 9/11 report as causation, generally lightly mentioned topics when considering stock market concern.
In this apparent risk-on environment stocks have a decided risk-off attitude, and numerous investors can't logically understand why. In fact they are positively correlating with bond and gold prices and moving higher – one of several correlation oddities that currently underlie market structure.
Why are stocks sprinting higher in the face of seemingly logical headwinds? Kolanovic thinks it could be due to the integration of monetary and fiscal policy, an increasingly common notion, as well as demand factors from equity inflows bond and international investors. Systematic strategies, which Kolanovic estimates are almost at portfolio capacity with equity exposure, are also seen as contributing to higher stock price momentum.
Kolanovic says Brexit stock market rebound was due to central bank intervention
A significant question surrounding the Brexit vote was how the stock market managed to rise higher after initially faltering. This price action, categorized as the “Brexit V bottom” in some algorithmic circles, left systemic market analysts confused. Here Kolanovic has a rather controversial notion: Central banks artificially pumped up markets.
This isn’t the first time this charge has been levied, but it is the first known instance of major derivatives analysis accusing central bankers of such direct market manipulation occurring in an official bank research report. Kolanovic was verbalizing an active and important conversation for anyone in the markets:
….the quick bounce of both the S&P 500 and 10-year bonds to all-time highs point to the overwhelming influence of central banks on asset price formation. This impact can be direct via asset purchases or indirect via distorting relative valuations of bonds to equities or valuation of assets in different regions.
Kolanovic did not offer statistical evidence of central bank manipulation in his report. When asked to provide backup for his charges or explain logic behind his modeling, JPMorgan did not return comment before publication time.
The topic of central bank intervention into sovereign bond markets has been documented. But central banks direct involvement in stock or commodity markets has only been lightly addressed in public. Hedge fund manager Paul Singer addressed the edges of the topic in a 2015 investment letter but did not provide evidence. Kolanovic, a man best known for being the first derivatives analyst to predict a flash crash, is also the first major analyst to point to a specific market event and claim prices moved higher due to central bank involvement.
Volatility is likely to rise just as volatility targeting and risk parity strategies have increased long stock exposure
Kolanovic, in accusing central banks of Brexit market intervention, is likely raising the volatility of polite and often hushed discussion inside financial industry circles. The same volatility spike could happen around the stock market.
“Realized volatility of US stocks is bound to rise, and current divergences between the S&P 500 and other assets such as oil, CNY, Eurostoxx 50, and Nikkei are likely to close.”
The lowering of volatility that has taken place recently is a facade that can be recognized by looking at the steep contango in the VIX futures markets. The close to expiration months are near all-time lows but further out months are pricing in a higher degree of volatility. Those trading volatility have been known to consider the "true" level of implied volatility by averaging the delivery months. Sometimes this can be tempered by adjusting month weighting to afford second or third expiration months additional importance.
Option exposures that are pressuring volatility should roll-off, and investors should increase leverage and set protection closer to the current market level. This will set the stage for a more rapid increase in volatility. We have seen these switches between extreme low and high volatility that manifest themselves as high volatility of volatility (e.g., note that that the current “once in 10,000 year” market calmness came after a Brexit day move that was “a once in 50,000 year” move for EuroStoxx 50 index).
The collapse in near-month volatility has led Risk Parity and Volatility Targeting strategies to ramp up exposure to stocks, Kolanovic observed. This could occur just as volatility is set to rise, once again exposing a systematic strategy to crisis it appears not to be able to handle. The lack of modeling through market environments with the risk parity and volatility targeting strategy has raised flags of concern inside systematic trading circles. The lack of strategy performance and the risk the strategies put on investors has been duly noted by multiple derivatives analysts, including Kolanovic.
Kolanovic: CTAs and long / short strategies are heavily invested in long stock exposure
In regards to systematic strategies, Kolanovic estimates that CTAs and long / short strategies have stocks more than well-represented in their portfolio. CTAs have equity exposure in the 75th percentile while fundamentally-driven Equity Long Short hedge funds are near the 90th percentile in long exposure. CTAs would be at record highs if it wasn’t for a divergence between US and foreign market price momentum.
In other markets, shorter-term CTAs have moved to mildly negative on oil, Kolanovic projects. He thinks trade triggers for medium- and longer-term CTAs might not be hit immediately as he eyes a low mark for a turnaround in oil positioning. Currently he thinks oil would need to drop to nearly $30 per barrel in order to trigger execution signals. Apparently looking at a downward sloping trend in the relative value among price averages, Kolanovic also says a stagnate oil market will eventually turn into a sell signal:
The more significant downside risk for oil would come in 6 to 8 weeks, at which point short-, medium-, and long-term momentum would turn negative even at current price levels (and likely lead to a significant selling from CTAs).
If Kolanovic is correct on his $30 momentum trigger for oil, that trigger level is likely to persistently rise with time.